Wednesday, December 22, 2010

Commercial Banking in 2011

Commercial banking in the United States is going to change substantially in the next five years.

Most of my comments on the banking industry over the past year have been spent on the “smaller” banks, the banks are not among the 25 largest commercial banks in the industry, the banks that control about 30% of the banking assets in America. At last count there were a little less than 7,800 of these banks. The average size of the banks in this category is about $480 million, pretty small.

My concern about these banks is their solvency. The FDIC placed 860 commercial banks on its list of problem banks at the end of the third quarter. The question that is still outstanding is how many more banks are seriously challenged to remain in business. That is, how many banks are not on the problem list but “near” to being on the problem list. Elizabeth Warren gave testimony in front of Congress in the spring and stated that 3,000 commercial banks were threatened by bad loans over the next 18 months.

Commercial banks have been closed at the rate of approximately 3.5 per week during 2010 and many other acquisitions have taken place. So, the industry is shrinking. I still believe that there will be fewer than 4,000 commercial banks in the United States by the end of the upcoming decade.

However, something new is going to happen at the other end of the banking spectrum. International banks are going to play a much bigger role in the United States in the future and this is going to substantially change the playing field and will help to accelerate the decline in the number of banks in the American banking system.

What’s going on? Just in the recent past we have had the news that the Bank of Montreal, the fourth largest bank in Canada, acquired the banking firm of Marshall and Ilsley Corp., which has $38 billion in deposits, 374 branches throughout the Midwest, and is the largest lender in Wisconsin. Then we learned that TD Bank, the second largest bank in Canada, is acquiring Chrysler Financial, the former lending wing of the Chrysler Corporation.

We also learn that Deutsche Bank AG and Barclays PLC have moved up the rankings of global business when compared to other Wall Street organizations. (See the Wall Street Journal article “New Banks Climb Wall Street Ranks,” These organizations have grown substantially filling in some of the hole left by the collapse of Lehman Brothers, and the moving of Bear Stearns and Merrill Lynch into other banking firms.

The point is that the American banking scene is much more open to foreign competition on its own turf in the 2010s than it was previously. This has the potential for causing even more changes in the structure of banking in the United States and in the world than we have seen over the last fifty years.

If we go back to the start of the 1960s, the United States contained some 14,000 commercial banks and a large, prosperous thrift industry. But, things were changing. Let me point out just three of the major factors impacting the banking and thrift industries by the start of the 1970s. First, was the beginning of the credit inflation that was to spread throughout the economic system that would result in the rising interest rates which would eventually bankrupt the thrift industry and drive it out of business.

Second, the United States commercial banking system at the start of the 1960s was a mish-mash of banking rules. For one, the branching laws were such that banks could not branch across state lines, and in some states banks could only have one office, in others they faced severe limits on the number of branches they could have, while in other states there was unlimited state-wide branching.

What broke this structure down? Information technology. With the spread of information technology banks could not be constrained from branching across state lines. The death knell for state control and limited branching was sounded. National competition became the new norm and banks had to compete.

The third factor was the freeing up of the flow of funds internationally. By the end of the 1960s the capital flows were basically unrestricted between the United States and Europe. One of the major signs of this openness was the creation of the Eurodollar deposit which became an important tool in the move to “liability management” which freed up American commercial banks from limits on their ability to grow their balance sheets. This factor contributed to the demise of the “Bretton Woods” system of international finance.

All three of these factors played a big role in the changes in the financial system of the United States and the world and to the movement away from “relationship finance” and “arms-length finance”. For more on the changes in the banking system and the growing “impersonal” nature of the financial system see the book “Saving Capitalism from the Capitalists” by Raghuram Rajan (the winner of the Financial Times/Goldman Sachs award for the best business book of the year, “Fault Lines”: and Luigi Zingales, both of the University of Chicago.

All of these factors are still at work but we are now seeing another important factor coming into play, “competition from the outside.” Just as the forces inside the United States have been attempting to build up walls to constrain the finance industry, America is now coming to experience a breaking down of the barriers. Unless the Congress puts up restrictions on foreign financial interests acquiring domestic companies, it seems as if the door is opening for more and more banks from outside the United States to come knocking.

The result of this “opening up” according to Rajan and Zingales is that the new competition really “shakes things up.” I have contended throughout the events which began in late 2008 that by the middle of 2009 the largest 25 commercial banks in the United States had moved beyond most of the structural problems that contributed to the financial collapse. Furthermore, by the time that the Dodd-Frank Financial Reform bill got passed, these banks had moved beyond most of the onerous portions of the legislation.

Now with these foreign financial organizations moving into the competitive space of the United States banks, all banks will be using information technology and uncontrolled capital flows throughout most of the world to further outpace efforts of regulatory reform.

Another consequence of this will be the pressure on the larger banks to continue to merge and acquire and diversify their businesses in ways we have not yet imagined. And, when one brings into the picture the things that information technology can do and the progress the “Quants” have made in finance, one can only guess at how exciting the near-term evolution of the banking system is going to be.

Merry Christmas and Happy New Year to Everyone!

Tuesday, December 21, 2010

Long-term Treasury Yields in 2011

Yesterday, I attempted to lay out how I thought 2011 would play out in terms of the value of the United States dollar. In “The U. S. Dollar in 2001” ( I argued that the general outlook for United States monetary and fiscal policy was more of the same policy stance that the United States government had taken for the last 50 years: credit inflation. (For more on this see the Financial Times/ Goldman Sachs business book of the year, “Fault Lines” by Raghu Rajan:

The year 2011 will follow the pattern of large fiscal deficits and monetary ease and this will carry into the foreseeable future. As a consequence, the long term direction of the value of the United States dollar will be downward. I focus on this initially because this sets the stage for how financial market participants view the actions of the United States.

This downward movement, however, will be interrupted in the short run by the continued problems relating to the sovereign debt of various countries within the European Union. The United States, in 2011, will still be seen as a refuge from risk which will result in the dollar being supported by a “risk averse” investment community through much of 2011.

The turmoil in Europe is taking the pressure off of the policy makers in Washington, since they will be free of any criticism that might come their way because of a declining value of the dollar. As a consequence, the Obama administration will not need strong leadership to execute an “unpopular” monetary or fiscal policy: this was the case in the late 1970s and early 1980s as Paul Volcker, leading the Federal Reserve, put the brakes on the economy and the value of the dollar rose significantly; and Robert Rubin, leading the Treasury Department in the 1990s, helped to bring the federal budget from a deficit to a surplus, which produced another significant rise in the value of the dollar.

So, my basic expectation for the economy for the next year (and for the near future) is similar to that being called “the new normal”. The new normal incorporates sluggish economic growth, high unemployment, and weak inflation. (See “Champions of the ‘new normal’ stick to their guns,”

The sluggish economic growth of the United States will remain around 3.0 percent to 3.5 percent, year-over-year, something way below what ordinarily has occurred in economic recoveries in the past. This modest growth rate under-scores the structural problems exhibited in the economy, the unusually low level of capacity utilization on the part of industry, the fact that the under-employment rate will remain in the 20 percent to 25 percent range as employers remain reluctant to bring back workers on a full time basis, and the fact that the year-over-year rate of growth of industrial production has been dropping off every month since June 2010.

I do see three ominous clouds on the horizon present in the financial sector. First, the solvency problems in the smaller commercial banks will continue to linger. As readers of this column know, I believe that the Quantitative Easing on the part of the Federal Reserve is more to keep the banking system afloat as the FDIC closes a sizeable number of banks over the next year or so. This will keep a lid on bank lending.

Second, there are the financial problems being experienced by state and local governments and these problems spill over into the financial markets for the bonds of these entities. The implications of this situation for the reduction in budges are huge.

Finally, large corporations have accumulated a huge chest of cash (both in the United States and Europe). It is my belief that this accumulation of cash is for “buying” purposes and we will see a sizeable pickup in mergers and acquisitions as the economic recovery continues. But, this restructuring of the economy will not create more jobs and increase production. In fact, it will do just the opposite. Large banks will also participate in this expansion of mergers and acquisitions. And, the big will get bigger.

Overall inflation will remain moderate. The year-over-year rate of increase in the implicit price deflator of gross domestic product remains around 1.0 percent and this probably will not go much above 1.5 percent this year, if it goes that high. Thus, general inflation does not seem to be a near-term problem.

However, given the current stance of monetary policy we see the possibilities of bubbles forming all over the place. (See “The Fed: Bubble, Bubble, Everywhere,” As we saw over the past 25 years or so, general inflation was low and policy makers felt under control of things. Yet we saw bubbles here and bubbles there. Now, the actions of the Federal Reserve are being picked up in a rise in commodity prices, rising stock markets of emerging nations, and the buildup of inflationary pressures in export driven countries like China and Germany.

Putting this all together, my view of long term Treasury yields for 2011 is up, with the 10-year Treasury security reaching 4.5% to 5% in the upcoming year, a rise from around 3.3% to 3.5% now. The 30-year Treasury security will rise to the 5.5% to 6.0% range, up from around 4.4% to 4.5% now. The spread between the yields of these two maturities will be about 100 basis points, slightly lower than it is at the present time.

Bernanke will not be able to keep long-term interest rates down!

This just puts long term Treasury yields back at the levels they were for much of the 2000s.

From this, I argue that the long run expectation for inflation built into these securities would be in the 2.0 percent to 3.0 percent range. For myself, I find that this level of inflationary expectations over the next ten to thirty years is low. But, that is another story.

The major uncertainties in this picture? The first uncertainty pertains to the stability of the banking system. I believe, however, that the Federal Reserve will continue to flood the financial market with liquidity in order to allow the failing banks to be worked off in an orderly fashion. If this occurs, the recovery will continue but at a slow pace.

The second uncertainty pertains to state and local finance. My feeling is that the federal government will not allow this situation to get out of hand. Welcome to the bailouts of 2011.

The third uncertainty pertains to the bubbles that have been created or are being created. As we have learned, bubbles can last only so long. The question will remain about how long the bubbles created will last. Given that the Fed will continue to flood the market with liquidity, it is unlikely that the world will be bubble-free.

One thing mentioned above I believe will be an uncertainty only in timing. That is the increase in the amount of mergers and acquisitions taking place. I believe that 2011 will see a continuation in the acquisition splurge that has already started and will continue beyond this coming year. The only uncertainty related to this is the reaction of the federal government to the bigger companies. My guess is that the new Congress won’t challenge this and the Obama administration will not have the will to challenge it.

Monday, December 20, 2010

The United States Dollar in 2011

I still believe that the long term trend for the United States dollar is downward. For the near term, for 2011, I believe that the United States dollar will remain relatively strong, at least against the other major currencies in the world.

My reasoning for the belief that the long term trend for the United States dollar is downward is based on the fact that the fundamental economic policy of the United States has been and will continue to be one of credit inflation. I explain this stance using the following chart.

The general trend in the value of the United States dollar reflected in this chart is downward. If one begins in March 1973 when the value of the index was set at 100, in November 2010, the value of the dollar declined by 27 percent.
The decline in the value of the dollar since the United States floated the price of the dollar internationally in August 1971 is even greater. Rough estimates place the decline in the value of the dollar from the time it began to float against major currencies until March 1973 between 15 percent and 20 percent. This would place the decline in the value of the dollar since it was floated through November 2010 roughly at 35 percent to 40 percent.

The underlying cause of this decline in the value of the dollar began in the early 1960s as the fundamental philosophy of economic policy in the government shifted to one in which a low level of unemployment became the over-riding goal of the fiscal and monetary policies of Washington, D. C.

The immediate results of this shift in economic philosophy was the destruction of the existing “fixed-rate” international foreign exchange system as capital flows opened up throughout the world and it became impossible to maintain fixed exchange rates in the face of independent national economic policies. A world of credit inflation became the norm.

There were two interludes, that of the Volcker monetary tightening in the early 1980s and the Clinton efforts to balance the government budget in the late 1990s. These periods, however, were just temporary diversions from the basic economic thrust of the policies of both Republicans and Democrats over the full 1961 to 2010 period.

I believe that the longer term trend in the value of the United States is still downward because the fundamental economic philosophy of the United States government has not changed. Credit inflation is still the basis of any policy being proposed by the government and this has been re-iterated over and over again by the economic policy spokesman of the Obama administration, Fed chairman Ben Bernanke.

I expect that federal budget deficits over the next ten years will total more than $15 trillion and the monetary policy of the government will just support the placement of that debt over time.

I don’t see any leader in Washington with the foresight or the strength to build a more sensible economic policy. That is, I don’t see anyone “in place” or on the horizon to pull off efforts at constraint like we saw in the early 1980s or the latter part of the 1990s. Thus, the basic fundamental economic strategy of credit inflation will continue to rule Washington, D. C. for the indefinite future.

The thing that will arrest this decline in the value of the dollar in the short-run is the situation in Europe. In a real sense the United States dollar is being protected in the short-run by the fact that the lack of leadership in Europe exceeds the lack of leadership being exhibited in the United States. One does not see this situation reversing itself in 2011. The value of the United States dollar will not deteriorate further against the Euro (and some of the currencies of other major developed nations) in the coming year.

Here the scale is reversed from the above chart. The Euro weakens against the United States dollar in the early part of 2010 as the sovereign debt crisis worsened in Europe. Around June in the year some confidence picked up as the European “bailout plan” for some of the perimeter European nations seemed to be coming together. As the summer wore on, doubts arose about the potential success of the effort. This backing off continued until the speech administration spokesperson Bernanke gave at Jackson Hole, Wyoming putting forth the idea of what is now referred to as QE2, Quantitative Easing 2.

The European financial situation once again came to dominate this foreign exchange market as the problems in Greece, the accelerating political and economic problems in Ireland, were coupled with downgrades to Portuguese debt and this has now expanded to potential downgrades to Spanish debt and other “non-perimeter” countries like France and Belgium. Confidence in the leadership within the European Union continues to fall: this chaos is seen as the dominating drama still to be played out.

So to summarize: in the longer-run, the value of the dollar can be expected to decline. The reason is that the political and economic leadership of the United States does not seem to have learned much over the past 50 years. However, this decline will be further interrupted for a while as European leadership continues to exhibit its greater incompetency.

There is one other development that I think it will be important to keep one’s eye on and that is the growing movement to conduct world trade in currencies other than the United States dollar. We see that Russia and China have moved in this direction. Brazil is also interested in moving in this direction as are several other countries that have not made a “big deal” out of it yet. The important point is that the “rest of the world” seems to be moving without the United States. This is just another example of the receding influence of the United States in world economic affairs.

Friday, December 17, 2010

America Must Start Again On Financial Regulation

Henry Kaufman, the Wall Street economist who formerly worked and gained his reputation as “Dr. Doom” at Salomon Brothers, Inc., has an op-ed piece in the Financial Times that raises a point that should be considered. The title of the article: “America Must Start Again On Financial Regulation.” (

Kaufmann’s basic point is that the Dodd-Frank Act “enshrined” the domination of big institutions in our financial system.

That is, the Dodd-Frank Act achieved just about everything it didn’t want to happen.

But, to be fair, the Obama administration efforts, not just in regulation, but also in its conduct of monetary and fiscal policy, has done about everything it can to achieve just the opposite of what it wanted to do.

And, as Ben Bernanke, the chief economic spokesman for the Obama administration has pointed out, the focus is still on unemployment and the means to bring unemployment down. The beat goes on, or the image Charles “Chuck” Prince, the former CEO and chairman of Citigroup, gave us was that “the music must keep on playing.”

For almost 65 years, the United States government has attempted to achieve something that it cannot achieve, “full employment.” This objective of the United States government was written into law, first in the full employment act of 1946 and then in the Humphrey-Hawkins full employment act of 1978.

In 1968, the economist Milton Friedman showed us that the government’s fiscal and monetary policy cannot achieve full employment. Friedman’s work, along with that of Edmund Phelps, another Nobel-prize winning economist from Columbia University, highlighted the insight that a government that brings about greater inflation cannot permanently reduce unemployment below a “natural rate of unemployment” by doing so. Unemployment may be temporarily lower than this “natural rate”, if the inflation is a surprise, but in the long run unemployment will be determined by the frictions and imperfections of the labor market.

Still, the Federal Reserve and other governmental agencies seem to act as if there is a trade-off between inflation and unemployment, a trade-off commonly called the “Phillips Curve.” Former Federal Reserve economist Ethan Harris confirms the use of the Phillips Curve in current analysis within the Fed in his book “Ben Bernanke’s Fed: The Federal Reserve after Greenspan.”

As a consequence, the United States government has followed an explicit policy of credit inflation since the early 1960s. The gross debt of the United States government has increased by more than a 7 percent compound rate of growth since 1960. This, and the accompanying monetary policy, has resulted in a massive increase of debt in the private sector accompanied by a substantial increase in risk taking. The environment has been optimal for the production of financial innovation and the massive growth of the financial industry and financial institutions.

And, everything that the federal government seems to do just further contributes to the growth of financial institutions and the growth of federal debt.

The question needs to be asked, “Why do the financial giants on Wall Street need to lobby the federal government?” One could make the argument that the federal government has basically been under-writing the growth of the financial industry and the proliferation of financial innovation for much of the last fifty years.

Maybe the efforts of the financial giants on Wall Street to “cry wolf” every time the federal government talks about regulating or re-regulating the finance industry and further lobby the federal government is just a cover.

The biggest financial institutions are doing just fine, thank you. But, they don’t want you to know it.

Many of my posts over the last year and one half have discussed the fact that the “movers and shakers” in the financial industry have come out just fine. As Kaufman asks in the above mentioned article, what happens when a large financial institution gets into trouble? The answer he gives: the only institutions that can absorb a large, troubled financial institution is another large financial institution. If Bear Stearns goes down, JPMorgan Chase picks it up. If Merrill Lynch goes down, Bank of America picks it up. The large financial institutions just get larger.

Regulation is not useless, but the misled efforts of the Congress to regulate the financial industry often overshadow the good that regulation can do. Unfortunately, Congress, in attempting to re-regulate the finance is primarily fighting the “last war”. This is always the “wrong war”.

The new regulatory environment is basically “out-of-date” on arrival. I have argued in post-after-post that the Dodd-Frank Act is a bill that is, by-in-large, irrelevant because the largest commercial banks had moved well beyond the legislation by the time that the legislation passed.

To me, the federal government needs to focus on three things going forward with respect to economic policy and financial regulation. First, the federal government needs to get its focus off of short run efforts to achieve full employment in the economy. It cannot be done and the credit inflation that follows only creates problems that must be dealt with later, as we have been dealing with the aftermath of fifty years or so of credit inflation. To reduce un-employment and under-employment, policies must be put in place that take a longer time to achieve desired results, but the results are longer lasting and more consistent with current market needs. However, this is hard for politicians to do.

Second, the government must work to obtain greater openness and transparency in the financial markets. In this information age, more and more information is readily available and should be available on a timely basis. If the Wikileaks episode shows us anything it is that in most cases it is very difficult to keep information. One would think that organizations, including financial institutions, would want to get out “ahead of the curve” with respect to providing information to the world by advocating more and more openness and transparency of their own data. If they don’t, the message is that someone else will provide the openness and transparency. Let’s “open up” in a voluntary and well-thought out way.

Third, create regulatory efforts that use market based early warning systems, like the one proposed by Oliver Hart and Luigi Zingales. (See my post In this information age, old-style regulation is ineffective if it is of much use at all. A lot of people are really going to have to re-think the whole regulatory environment.

The bottom line is that it appears as if we are getting “more of the same.” The only thing Bernanke knows is how to throw spaghetti against the wall. (See But, more of the same is more and more emphasis on unemployment and the provision of liquidity to the banking system. This is the short-sightedness that Milton Friedman warned us all about. I guess fifty years of economic policy failure is not enough of a lesson.

Thursday, December 16, 2010

Long-Term Yields, the Fed and QE2: The Weekly Fed Data

The 10-year United States Treasury issue backed off somewhat today. At 4:00 pm in New York the bond yielded about 3.43 percent, up from about 3.23 percent last week at this time. On Wednesday December 15, these bonds yielded around 3.55 percent, up from the previous Wednesday close of 3.30 percent.

Both Martin Wolf at the Financial Times and Jeremy Siegel, of the Finance Department at the Wharton School, in the Wall Street Journal attributed this rise in interest rates to the strengthening of the economy, which they both took as a good sign.

Although I hear their arguments, I am not quite convinced. This year, the yield on this 10-year security fell from a range of 3.80 percent to 4.00 percent in the March/April time frame. This fall in rates was attributed to the financial turmoil going on in Europe.

As can be seen in the chart, the rate feel almost constantly until late August. And, what happened in late August? Ben Bernanke spoke about QE2 at a Federal Reserve conference in Jackson Hole, Wyoming and guess what? The yield on the 10-year bond started up immediately and has continued to rise ever since. The timing of the rise was very specifically connected with the Bernanke speech and subsequent Fed releases. Where did the strength of the economy come into play? Wolf and Siegel just aren’t convincing.

So, the long term bond yield is rising. This isn’t what was supposed to happen. So the Federal Reserve got active. I reported this last Thursday evening as soon as the Fed statistics were released. (See

Here is a part of what I said, “The Federal Reserve added over $32 billion in Treasury notes and bonds to its portfolio from Wednesday, Dec. 1, to Wednesday, Dec. 8. This move was not to replace mortgage backed securities as was the case over the past few weeks.
Also, this increase was not to replace reserves lost through operating transactions. Quite the contrary, deposits with Federal Reserve Banks other than reserve balances, which includes the General Account of the U.S. Treasury, fell by almost $8 billion, which also added reserves to the banking system.

All-in-all, over $50 billion was added to Reserve Balances with Federal Reserve Banks over the past week. Most if not all of this will show up in Excess Reserves at commercial banks.”

This week the Fed bought more United States Treasury securities, but this time the purchases were a substitution for the securities that were maturing in the Fed’s portfolio of mortgage backed securities. The Fed purchased outright $18 billion in United States Treasury securities. This went to offset a decline in the mortgage backs securities of almost $14 billion.

Net, the Fed supplied reserve funds in the amount of $3.5 billion. (The figures don’t match exactly because of other small changed that took place in the balance sheet.)

An interesting aberration took place in the data released at 4:30 PM today. The Fed statistics show that the “average” increase in the United States bond portfolio for the week was $23.6 billion and the decline in mortgage backed securities was $2.0 billion. These figures differ from those given above because the figures above relate to the Fed’s balance sheet as of the close of business on each Wednesday. The figures reported in this paragraph relate to the average of daily figures for the week ending each Wednesday. The only thing that can be said about the two sets of figures is that most of the purchases of Treasury securities for the week ending December 8 must have come on Monday, Tuesday, or Wednesday of the week so that the weekly average was closer to the portfolio held for the week ending December 2. That is why the numbers relating to the weekly average are so large relative to the end-of-week numbers.
Reserve balances with Federal Reserve Banks, a proxy for commercial bank excess reserves, fell by about $64 billion during the week. The primary cause of this was an increase in the general account of the Treasury held at the Federal Reserve. These Treasury deposits rose by $72 billion during the week as the Treasury sent out checks to the private sector and withdrew funds from the government Tax and Loan accounts held at commercial banks.

This movement between accounts was purely an “operational” transaction and should not be considered a part of the QE2 process.

So, the conclusion for the week is that Federal Reserve open market operations for the week were primarily a substitution of United States Treasury securities for maturing mortgage backed securities. Thus, it seems that very little effort was put into trying to keep interest rates from rising.

The 20 to 25 basis point rise in the yields, seemingly, were not resisted by the Fed.

Wednesday, December 15, 2010

Housing Still in Cumulative Downward Cycle?

Why would financial institutions want to put home mortgages on their balance sheets right now?

Answer: they really don’t want to add mortgages to their balance sheets.

The consequence is that very tight credit standards exist for mortgages at the present time, a time when credit standards have usually been increasing as the economy comes out of a recession. A Federal Reserve report covering the third quarter of 2010 showed that 13 percent of bank loan officers stated that they were working with tighter requirements. Only 4 percent stated that they were working with easier ones.

Banks, of course, are not issuing non-governmental mortgage-backed securities. In fact, the amount of mortgage-backed securities outstanding has plummeted beginning in 2008. Federal Reserve statistics indicate that privately issued pools of home mortgages fell by $310 billion in 2008, by almost $340 billion in 2009 and have fallen by about $230 billion in 2010.

Agency- and GSE-backed mortgage pools are increasing but at a rate way below previous levels.
In 2008, home mortgages totaled over $11.1 trillion; at the end of the third quarter of 2010, there was only about $10.6 trillion in home mortgages outstanding in the United States, a 4.5 percent drop.

It is apparent that financial institutions do not want to hold mortgages on their own balance sheets and if they cannot securitize them and sell them then they just don’t originate them.

There appears to be two reasons contributing to this behavior. First, delinquencies and foreclosures are still increasing at near record rates. Trying to work out loans that are delinquent and carrying out the process of foreclosure takes time and human resources, resources that could be used to originate mortgages. Second, home owners do not seem to be borrowing if they don’t have to. Mortgage applications have fallen by more than a third from the levels reached in late 2008 and show an almost continuous decline in 2010. Why should home people move if they don’t have to and home prices continue to decline?

Furthermore, Fannie Mae and Freddie Mac have gotten very aggressive demanding that commercial banks buy back defaulted loans if it can be shown that the mortgages Fannie and Freddie acquired were not originated under stated underwriting guidelines. Financial institutions are scared due to the fact that if they have to buy back defaulted loans…it may put them out of business.

Why should the affected banks make any more loans if they might go out of business? Making loans under these circumstances is just a waste of time.

In terms of home prices, has reported that home prices will have dropped by about 7 percent in 2010. In 2011, Fitch Ratings has projected a further 10 percent decline in home prices.

The dynamics of the housing market, therefore, is that falling employment and incomes are still a problem in many sectors of the economy. Banks are not very willing to originate new home mortgages and have tightened requirements to obtain loans. Housing prices fall because the demand for homes has dropped and there is a large inventory of foreclosed properties on the market. This puts more homeowners “under water” with respect to the outstanding loan values they have. And the cycle continues…downward.

Given such a cycle, there is very little incentive for financial institutions to put home mortgages
on their balance sheets.

But, there is another possibility threatening the value of the home mortgages already on the balance sheets of commercial banks.

Fannie Mae and Freddie Mac are reported to be in discussions with people from the Obama administration seeking support for a program to write down loan balances on home mortgages where the borrowers mortgage is greater than the current market price of their homes.

Doing so would help these home owners by “forgiving” the amount of the loan that is underwater. This would reduce the probability of more foreclosures due to a mortgage being underwater and it would also have the effect of reducing loan payments. The “write down” would cost the American taxpayer as the government would have to pay for the amount written down.

Even more scary is the fact that if Fannie Mae and Freddie Mac start to reduce loan amounts to levels that are more consistent with current prices, what pressure would be put upon commercial banks to do exactly the same thing? And, this pressure would seemingly grow as the next Presidential election came nearer.

Commercial banks, both the largest 25 banks in the country and those smaller than these 25 banks, have slightly more than 14 percent of their assets in home mortgages. How much of a hit could these banks absorb and still remain solvent?

Even a little more “write down” in the face of all the other problems that reside on the balance sheets of the banking system would seem to be very troublesome. (See, for example,

The banking industry is fighting such a write down.

The problems existing banks are facing just seem to go on-and-on. Is it any wonder that the banking system, as a whole, is shrinking its loan portfolio? Is it any wonder that federal regulators are continuing to “prop up” the banking system so that these difficulties can be worked out as smoothly as possible? Is it any wonder that the banking system is not contributing to the economic recovery?

Even with some economic recovery taking place, there are still areas of the economy…housing and commercial real estate…that seem to be in on a cumulative downward cycle.

Tuesday, December 14, 2010

Known Unknowns: Debt Refinancings in 2011

When does a financial institution write down an asset?

To those in the banking industry the answer has always been, “Not until I am not responsible for that portfolio anymore.”

My experience with lenders is that when making a loan they tend to be pessimistic and, in addition, require collateral. Unless, of course, they are securitizing the asset created and selling it off.

However, when overseeing a loan portfolio, lenders tend to be very optimistic. “Well, the borrower is just experiencing a slight setback, but things will get better.” “The economy is going to improve soon and then the loan will be alright.” “Yes, the borrower made a mistake, but he has learned from the mistake and is getting his act in order.”

Lenders (bankers) are reluctant to write down anything if they don’t have to. And, this applies to all aspects of their asset portfolios.

But, a big cloud is hanging over the financial industry going into 2011 in the United States, and also in Europe. The big cloud relates to number of bank assets that will need to be refinanced during the year. These numbers are staggering.

My guess is that this is one of the major reasons why commercial banks are not lending now. (See “Little or No Life in the Banking Sector,” Banks do not want to write off any more assets now and are reluctant to add any more funds than they have to in order to build up their loan loss reserves. They add to these reserves as little as possible, as little as the regulators will let them get away with, so that they can build up their equity capital positions. If they then let the loans that are maturing run off without replacing them, their capital positions improve. The debt/equity ratio can fall as debt can be reduced while capital is being increased.

Making new loans does not fit into this strategy because the new loans will have to be financed and that will tend to raise the debt/equity ratio. So commercial banks are not lending now.

So what is this cloud and why is it so scary?

There are two specific areas that are being highlighted these days that stand out as potential problems for the banks: the first is the commercial real estate sector; and the second is governments, local, state, and nation.

In all cases a lot of loans or securities are going to mature in 2011 and the bet is that a large number of these assets that are found on bank balance sheets will either not be sufficiently credit worthy to be able to refinance or will not be able to handle the interest rates they will have to pay on the new debt to be issued..

In November 2010, commercial real estate loans made up almost 40 percent of the loan portfolios of the banks not among the largest 25 commercial banks in the United States and over 25 percent of their total assets. If these “smaller” banks had to write down 10 percent of their commercial real estate loans that would amount to about 3 percent of their assets: a substantial blow to their capital positions.

The problem is not so great in the largest 25 banks in the country as commercial real estate loans make up only 14 percent of their loan portfolios and about 8 percent of total assets.
This situation is the one pointed to by Elizabeth Warren in congressional testimony when she stated that 3,000 commercial banks, primarily the smaller ones, faced substantial problems ahead in this part of their loan portfolio.

The other problem mentioned has to do with government securities. More and more concern is being expressed about the condition of the finances of state and city governments in the United States. Layoffs are taking place all over the place, with many of the layoffs threatening health and safety. Yet, there is still substantial concern that the unfunded commitments of these state and city governments embedded in their pension funds have not really fully been addressed.
They may have to be addressed in 2011.

And so we get articles like “Bankrupt City, USA” ( which carry statements like this, “A Congressional Budget Office report reaches a conclusion to terrify investors in America’s $2.8 trillion municipal bond market. Municipal bankruptcy, permitted in 26 states, should be considered by city leaders to restructure labor contracts and debts.”

And the yields on municipal securities are the highest they have been in over a year. ( The situation related to state-issued securities is not too different.

The smaller banks, as defined above, have around 25 percent of their securities portfolio in state and local political issues. This makes up about 5 percent of the total assets of these banks. Again, a write down in this area could cause substantial damage to bank capital positions.
But, this problem relating to government debt is not constrained to United States banks. “Eurozone countries will have to refinance more debt next year than at any time since the launch of the euro amid investors’ warnings that the debt crisis in the region will intensify in the new year….Eurozone nations will have to refinance or repay €560 billion ($740 billion) in 2011, €45 billion more than 2010 and the highest amount since the launch of the single currency in January 1999.” ( Much of this debt is held by banks.

What would you do if you were running a bank and were facing the possibility that a substantial portion of your portfolio would have to refinance in 2011? Oh, by-the-way, you also have foreclosures and business bankruptcies running at a relatively high rate as well.

You probably would stop lending, try to shrink you balance sheet as much as you could without damaging profitability and build up as much capital as you could before the time of refinancing arrived.

The question that we don’t have an answer for at the moment relates to whether or not the bankers, themselves, have a good handle on which assets will present the biggest refinancing problems and just how much will have to be written off due to these refinancings. Are they still just “hoping for the best.”

In addition, a rising interest rate environment would be one of the worst scenarios possible given all the refinancings that are going to have to take place.

Happy New Year!

Monday, December 13, 2010

Little or No Life in the Banking Sector

If the economy needs the banking sector to get healthy before it begins to grow we are still waiting for the banks to show some signs of life.

In the past few months, loans and leases in the commercial banking system continued to decline.
Credit extension over the past six months was down about 2 percent and for the last three months it was down by 1 percent. Loans and leases on the books of commercial banks also declined by $18 billion over the past month.

The category of loans taking the biggest hit has been commercial real estate loans. For over a year now, concern has been expressed about the weaknesses that were expected in this sector and, to date; this forecast has been proven to be correct. The expectation is that the commercial real estate sector will continue to remain week in 2011.

Commercial real estate loans have declined by more than 9 percent over the past year, the largest declines coming in the largest banks in the country. These loans have declined by more than 11 percent at the biggest 25 banks in the country, while they have declined by almost 8 percent at the smaller institutions.

This trend also existed over the past six months, three months, and one month with declines for the whole industry of about 5 percent, 3 percent and 1 percent, respectively. Note these are not annualized rates.

It has been the case that the rate of decline in these loans has been greater in the largest banks.

Every classification of loan continued to decline over the last six months, with all real estate loans taking the lead.

Cash assets at all commercial banks registered declines over the past year as the Federal Reserve has been less generous in pumping out funds…until recently, of course.

Over the year, cash assets at commercial banks fell by 12 percent. However, there is another
story embedded in these figures! Cash assets at the largest 25 commercial banks fell by almost 30 percent over the past year, declining by 22 percent over the last six months and by 10 percent over the last quarter. Thus, one could say that the bigger banks were becoming less conservative in that they were relying less and less on balance sheet liquidity to see them through the upcoming months.

The story is entirely different for the smaller banks. Over the past twelve months, cash assets at domestically chartered commercial banks that were smaller than the largest 25 banks ROSE by more than 15 percent! Over the past six months, these smaller banks increased their holdings of cash assets by more than 5 percent. Only in the last month have cash balances declined at these banks, but the decrease was modest, at best.

My concern over the past twelve to eighteen months has been the health and solvency of the smaller banks in the banking system. Not only are loans at these institutions down significantly over this time period, their cash holdings have increased dramatically. The implication of this movement is that the smaller banks are being very, very conservative in their management in order to weather as well as possible the removal or write-down of bad assets from their balance sheets.

Over the past twelve months, the Federal Deposit Insurance Corporation (FDIC) has been closing approximately 3.5 banks per week. As of the end of September 2010, the FDIC had 860 banks on its problem bank list, up from 829 at the end of the second quarter. (Remember also that the FDIC closed about 45 banks during the third quarter.) The number of banks on the Problem Bank List now represents 11% of all FDIC insured institutions, a little over 7,800 banks in total. Furthermore, in judging this picture we need to recall that earlier this year Elizabeth Warren, in Congressional testimony, stated that there were about 3,000 banks facing severe problems in their commercial real estate loan portfolio.

One can interpret these data as indicating that the commercial banking system, especially the banks not included in the largest 25 banks in the country, is still facing serious difficulties. Not only are we getting this picture from the banking regulators themselves, we are seeing these banks acting very, very conservatively in the face of the massive injection of funds into the banking system.

It is this picture that leads me to believe that one of the major reasons the Federal Reserve has constructed QE2 is that the banking system continues to need support as the FDIC closes as many banks as it has to as smoothly as possible.

Furthermore, what could do more damage to asset values in the portfolios of commercial banks than to have interest rates rise?

The Fed says it is trying to keep interest rates from rising in order to help encourage economic growth, but maybe there is one step missing in this explanation.

The Federal Reserve needs the commercial banking system to start lending again so that businesses can begin investing again and the economic recovery can get on track.

However, the Federal Reserve needs to keep interest rates from rising so that financial assets in the commercial banking system don’t decline further and force even more banks to close their doors.

A substantial rise in interest rates would be disastrous for the banking system.

Also, if interest rates rise even modestly, it is highly likely that commercial banks, given the condition they are in, will act even more conservatively and be even more reluctant to pick up their lending to businesses and consumers.

The Federal Reserve needs a vibrant and active commercial banking sector in order to generate sustainable economic growth.

The Federal Reserve is not there yet.

Thursday, December 9, 2010

The Fed Acts!

Federal actions on QE2 have been relatively benign up to this week. (See my Monday post:

Things were different this week as the United States Treasury issued a lot of bonds this week and longer terms interest rates rose to levels not seen since the middle of June 2010. The 10-year Treasury security got up to almost 3.30 percent on Wednesday, up by about 45 basis points over the past two weeks or so.

The Federal Reserve added over $32 billion in Treasury notes and bonds to its portfolio from Wednesday December 1 to Wednesday December 8. This move was not to replace mortgage backed securities as was the case over the past few weeks.

Also, this increase was not to replace reserves lost through operating transactions. Quite the contrary, deposits with Federal Reserve Banks other than reserve balances, which includes the General Account of the United States Treasury fell by almost $8 billion which also added reserves to the banking system.

All-in-all, over $50 billion was added to Reserve Balances with Federal Reserve Banks over the past week. Most, if not all of this will show up in Excess Reserves at commercial banks.

In August 2008, before the Fed started pumping reserves into the banking system, total reserves at all commercial banks totaled $46.4 billion!

The initial interpretation of this is that the Fed acted to keep long term interest rates from rising further. The ten-year bond rate was down slightly today, closing around 3.23 percent at 4:00 PM, New York time. This is what QE2 is supposedly all about!

Long-term Bond Yields and QE2

One of the fundamental things I learned when working in the Federal Reserve System and in running financial institutions was that the Federal Reserve could only temporarily lower long term interest rates.

In attempting to achieve a goal of lowering these rates, the yield on long-term Treasury securities would initially dip below its previous level and then rise to a point where it was above the previous level. The moral of this market behavior was that attempts to keep long term interest rates lower than the market desired only ended up causing the rates to go up as the market adjusted to the efforts of the central bank.

In my professional career I have not observed anything that would lead me to change this viewpoint.

Yet, supposedly, the QE2 efforts of the Federal Reserve are aimed at reducing the yield on long-term Treasury securities so as to encourage a more robust recovery of the economy. The argument given is that there is little or no indication that inflation will pick up because, if anything, the probability that we might enter into a period of deflation is high enough to be of concern.

As recorded in my post yesterday, I believe that on the subject of inflation/deflation, Ben Bernanke is a lagging indicator. He always seems to be behind what is happening. (See “The Fed: Bubble, Bubble Everywhere,”

Let me start from where I am. First, the United States economy IS recovering. However, this recovery is going to be a very slow one because of all the re-structuring that needs to be done within the economy of the United States. We have considerable under-employment with one out of every four individuals of working age being under-employed. We have a capital structure in which a lot of capital is not being used: current capacity utilization is around 75% and the previous peak “high” was only about 81%. We have built too many houses and there seems to have been too much development of commercial properties. There is still too much debt outstanding: more deleveraging needs to take place. And, this doesn’t even come close to touching the needs of our educational system. (See “Top Test Scores from Shangshai Stun Educators,” And, so on.

I just do not believe that monetary stimulus, or, for that matter, further fiscal stimulus is going to achieve much faster economic growth.

The financial system is still fragile and this, I have argued is the real reason for the Fed’s attempt to flood the world with liquidity. Banks, other than the largest 25 banks, are still extremely distressed. State and local governments face huge fiscal problems. And, the federal government is going to post $15-$18 trillion in new debt over the next ten years given the current budgetary posture. Financial markets must be kept calm so that the FDIC and others can work off insolvent banks; where pension accounting in government can be brought into line; and assets values can be written down throughout the economy.

Let me reiterate: the economic recovery is progressing.

And, what about inflation?

According to the implicit price deflator of Gross Domestic Product, inflation was running at about a one percent year-over-year annual rate in the third quarter of this year. I prefer this measure of inflation as opposed to the Consumer Price Index (CPI) because of all the expert “fussing” with this latter measure over the past 15 years. Also, I do not really trust an indicator that has a large component relating to the rental price of owner-occupied housing that is estimated and has been shown to have substantial biases.

As can be seen from this chart, the year-over-year rate of change in prices did not turn negative during the Great Recession and seems to be on a relatively steady upward movement. It is my belief that the inflation shown in the GDP Implicit Price Deflator will continue to rise, but not explosively.
That is, the economy will continue to grow, but only modestly over the near term. And, I believe that the longer-term trend in prices in the United States economy is up. Furthermore, I believe that the longer-term trend in the value of the dollar is down.

In terms of the last forecast I believe that the value of the dollar will continue to decline in world markets over time in spite of the best efforts of Europe to “prop up” the dollar through the absence of leadership and guts that seems to prevail in the halls of the European Union.

Now, back to bond yields. Within the scenario I have described above, I really cannot see how the Federal Reserve, through its QE2 efforts, can keep long-term Treasury yields down. I guess my major question becomes, is this really the goal of the Federal Reserve? Or, are the statements coming out of the Federal Reserve a diversion to keep people from looking too deeply into the continuing problems of the banking system, and of the state and local governments, and asset values? Are the efforts of the Federal Reserve just a holding action while the value of assets, those of banks, those of state and local governments, those of home owners, and those of businesses, are written down?

To me, long-term bond yields should rise over time. I just can’t see how the Fed can keep them down.

What is most disturbing in all of this to me is the fact that the Chairman of the Board of Governors of the Federal Reserve System has become the primary spokesperson of the Obama administration. Tim Gaithner has failed in that role; Christina Romer has failed in that role: and Larry Summers has failed in that role. Now, Ben Bernanke has become the voice of Obama on economic affairs. How sad!!!

Wednesday, December 8, 2010

Dodd-Frank Wall Street Reform and Consumer Protection Act

What do I think of the Dodd-Frank Financial Reform legislation?

I can't express it better than this:

The Dodd-Frank Financial Reform Act is already "legacy".

Bubble, Bubble, Everywhere!

The Federal Reserve just doesn’t seem to get it!

Monetary ease can cause bubbles and not just in the United States. Bubble Ben at the Fed still denies that the Federal Reserve had anything to do with the bubbles in asset prices in the early 2000s in housing and the stock market. Bubble Ben, in 2005, placed blame on the Chinese and other countries for the “Global Savings Glut” that helped to finance the budget deficits of the United States government thereby allowing the interest rates in the America and other countries to be excessively low, causing substantial concern about world inflation and international resource misallocation.

Bubble Ben continues to see price moderation as a problem, just as in 2006 and 2007 he saw inflation as a problem far beyond the period when inflation was a problem. When it comes to price movements and asset bubbles, Ben Bernanke is a lagging indicator!

What is happening in the real world, Ben?

We see the headlines, “Investors Pile into Commodities”, ( “Investors are holding their biggest positions on record in the commodities markets as prices surge…Hedge funds, pension funds and mutual funds dramatically ramped up their holdings in everything from oil and natural gas to silver, corn and wheat this year. In many cases, the number of contracts held for individual commodities now far exceeds the amount outstanding in mid-2008, the last time commodity markets were soaring to records and debate raged about whether excessive speculation was driving up prices.”

We read in the Financial Times, “Crude Oil Tipped to Bubble over $100 a Barrel,” ( “For the first time in two years, oil bulls are starting to outnumber bears.” Have you noticed that the price of gas has jumped $0.30 or so over the past month or two. And, the price of gasoline at the pump is going to continue to rise.

And the same picture arises for worldwide commodity prices, “Material Difference,” ( “World prices for cotton have risen by 73 percent since the start of June.” This is just one item; one can go to other commodities and see substantial increases. This is sure going to help the economic recovery?

“In other words, a generation that has grown up with food and clothing deflation must now get used to paying more for the shirts on their backs and the bread on their table. The options: less breakfast cereal in the carton and hair-raisingly static-inducing nylon shirts, or pummeled profit margins for the global food and clothing industry.” That is, world commodity inflation is causing cost pressures that must surface somewhere. And, this is going to help the recovery?
And, we are seeing China, Brazil, and India, among other countries, raising interest rates and restricting bank lending so as to combat increasing levels of inflation. Governments are very concerned.

Last week, the Federal Reserve released information about the financial and non-financial institutions that it assisted throughout the world during the recent financial crisis.

Commentators responded by referring to the Federal Reserve System as the “world’s central banker.”

The Federal Reserve System has become the “world’s inflator”!

International financial markets have become so interlinked and flows of funds have become so fluid that pumping up the world’s reserve currency can affect almost every corner of that world. If the Federal Reserve creates an environment in which investors can borrow at 25 to 50 basis points and lend elsewhere at much higher rates, money is going to flow from the United States into these other opportunities.

And, bubbles result...worldwide!

What the Federal Reserve fails to understand is that industry and finance in the United States is in need of a massive re-structuring. Efforts to pump funds into the U. S. economy in a short-run attempt to put people back to work is just resulting in the money going “off-shore”. These efforts are not helping people and businesses de-leverage and modernize; it is not helping them re-structure.

And, these efforts are not helping America compete in the 21st century when its educational system is just producing students that are average or just above average in science, math, and reading when compared with other children throughout the world.

Also, the Federal Reserve does not understand the role it has played in exacerbating the increasing gap in incomes between the highest earners and the rest of the income spectrum.

As a consequence, the Federal Reserve is just producing bubbles everywhere and it is hard to see how this is really going to help us.

Tuesday, December 7, 2010

America Continues to "Go Liquid"

The monetary story of the “Great Recession” is that the two most watched measures of the money stock, M1 and M2, have continued to grow, year-over-year, throughout the downturn and slow recovery. The problem with this is that the money stock measures have grown because Americans have almost continuously been moving their funds from less liquid assets into assets that can be used for transactions purposes.

In other words, Americans have wanted their assets where they can immediately spend them.

This is very obvious when we compare the year-over-year growth rates of the M1 and M2 money stock measures. For the last seven months, M1 growth has averaged around 6% (down from around a 13% average for the previous year). The M2 growth rate has been around 2.5% for the same time period (down from about 6% for the previous year).

The non-M1 component of M2 has grown at about 1.5% for the past seven months, much slower than the rate at which M1 grew over this same time period. The average growth of this measure for the previous twelve months was hardly different from zero.

This continued relative movement into “transaction accounts” is not a positive signal that the economic recovery will pick up soon. Americans still seem to be putting their funds into currency and checkable deposits because they need “ready” cash to spend on necessities. They are not saving for a rainy day for, to these people, the rainy days are here.

Another indication of the desire of Americans to have money available for spending is the continued high growth rates in the currency component of the money stock. Through much of the 2000s up until September 2008, the year-over-year rate of growth of the currency component of the money stock rose by less than 2.0%. For much of the time it was below 1.0%.

Beginning in September 2008, more and more Americans wanted cash on hand. At one point, the year-over-year rate of growth of currency rose to about 12.0%. Although the demand for currency has dropped off, the year-over-year rate of growth was in excess of 5.0% in October 2010 and around 6.0% in November 2010. This is another indication of the need for people to have money “ready-to-spend.”

This movement of funds is also reflected in the numbers for bank reserves. Total reserves in the banking system have actually declined, year-over-year, in the past two months. In November, total reserves were actually down by about 9.0%, year-over-year.(In the first quarter of 2010, total reserves were up 120.0%!)

Required reserves in the banking system, however, were actually up during this two month period. In November, required reserves showed a year-over-year increase of about 5.0%. This shows how the deposits at financial institutions have moved from time and savings accounts to checkable deposits that have higher reserve requirements.

As a consequence of this shift, excess reserves at commercial banks have declined slightly over the past several months. This decline has not been initiated by the Federal Reserve, but has resulted from the shift in deposits within the commercial banking system.

The Federal Reserve was highly criticized for the way it reacted to the period known as the Great Depression. As Milton Friedman showed, at one time, the Federal Reserve had allowed the M2 money stock to decline by about one-third. He attributed the Great Depression to the fact that the monetary authorities allowed the money stock to decline by such a massive amount.

The year-over-year growth rate of the M2 money stock measure has never dropped below zero over the past four years. This can be seen in the accompanying chart. In late 2008, this growth rate accelerated as people moved money into currency and checkable deposits. You can see the drop off as the most dramatic movements resided. The important thing, however, is that the growth rate of the M2 money stock measure never turned negative.

What are we currently watching for in these measures of money stock and reserve growth?

We are interested in an acceleration of economic growth. This acceleration will not take place until two things happen in the money stock measures. First, the movement of funds from assets that serve as a “temporary abode of purchasing power” (a term coined by Milton Friedman) to checkable deposits must be reversed. The movement from these interest bearing assets to checkable deposits indicates the weaknesses that exist on balance sheets and the need to keep funds available for current spending.

Second, commercial banks must begin making loans again. Banks, in the aggregate, still do not seem to be too willing to make loans and expand business and consumer credit. (See Until this starts to happen we will not see the checkable deposits at commercial banks beginning to rise again for reasons other than that people want to hold more checkable balances.

And, if time and savings accounts do not stabilize and begin to increase and banks do not start increasing their lending, the year-over-year rate of growth in the M2 measure of the money stock will continue to remain lethargic. This will be one indicator that the economy is not picking up steam.

If consumers, businesses, and banks do not start to change their behavior I cannot be optimistic about the success of the Fed’s efforts at quantitative easing, i. e., QE2 (see post of December 6, “Federal Reserve QE2 Watch: Part 1”:

Monday, December 6, 2010

Federal Reserve QE2 Watch: Part 1

Quantitative Easing, Part 2 has begun. As I wrote on November 4, 2010, “The Fed is going to purchase an additional $600 billion in US Treasury securities over the next eight months, or $75 billion per month, in order to get the economy growing again…over the same time period, roughly $250 to $300 billion will run off of the Fed’s mortgage-backed securities portfolio. This $250 to $300 billion in mortgage-backed securities will be replaced by $250 to $300 billion in U. S. Treasury securities. (See "The Fed's $850 billion bet":

The reason given for this policy is that the economy is not picking up fast enough and that unemployment is such a problem that the Fed must act in an extraordinary way in order to correct the situation. Nothing, however, is being said about the weaknesses in the commercial banking sector and the need to put a floor under asset prices so that the banking regulators can work out all the insolvent banks.

So, we are entering a new phase of monetary policy. It is very important to keep on top of what the Fed is doing so that we can try and understand how this quantitative easy is working and what impacts this policy is having on the banking system.

Remember, starting in July 2009, the Federal Reserve began to execute an “exit policy” to remove all of the excess reserves it had pumped into the banking system in the first round of quantitative easing. The Fed, in combating the “Great Recession” pushed the excess reserves in the banking system from about $2.0 billion to over $1.0 trillion. During this time, the balance sheet of the Fed grew from less than $900 billion to more than $2.0 trillion. The “exit policy” was an attempt to return the balance sheet to a size that was comparable to the earlier figure and substantially reduce the excess reserves in the banking system.

During the year or so that the Fed was engaged in its “exit strategy”, the Fed’s balance sheet actually increased and excess reserves in the banking system rose! (See

So much for an “exit strategy.”

Now for QE2! Given the directive mentioned above, there are three areas that we need to keep a close watch on. First, we need to watch what happens to the Federal Reserve balance sheet and what happens to the excess reserves in the banking system. This will tell us whether or not the Fed policy is expansive. Second, we need to watch the runoff in the portfolio of mortgage-backed securities (and Federal agency securities) to see whether or not the Fed is replacing the runoff with purchases of Treasury securities. Third, we need to see what “operational” factors are influencing the Fed’s balance sheet to determine whether or not the purchase of Treasury securities are going to support movements of funds connected with seasonal or other operation factors.

Over the last thirteen week period, Reserve Balances held by commercial banks at Federal Reserve banks actually declined by $2.0 billion.

In terms of the first point, it appears that the Fed did not act to aggressively expand bank reserves or the excess reserves held by the banking system.

In terms of the second point, during this thirteen week period, the Federal Reserve purchased roughly $131 billion in United States Treasury securities. However, the Fed’s portfolio of mortgage-backed securities and Federal agency securities declined by almost $90 billion. The net increase in Securities held outright by the Federal Reserve was more than $40 billion.

Two major “operational” events absorbed bank reserves during this period. These two events caused funds to flow out of the banking system and the Fed needed to inject reserves back into the banking system to replace them. This is what the above $40 billion in securities purchases went to do.

The first “event” that drained reserves out of the banking system was a flow of currency “out of” the banking system. This always happens as people prepare for the Thanksgiving and Christmas holiday seasons: people increase their holdings of cash for current spending purposes. Over the past thirteen week period, Currency in Circulation rose by almost $27 billion and had to be replaced.

The second “event “related to the recapitalization plans of American International Group (AIG). Pending the closing of the recapitalization plan, the cash proceeds from certain asset dispositions will be held by the Federal Reserve Bank of New York as agent. This account appears as a deposit (liability) on the Fed’s balance sheet and results from a flow of funds out of the banking system. Like currency flowing out of the banking system, this movement also has been replaced in the banking system through the Fed’s purchases of U. S. Treasury securities. This account rose by almost $27 billion over the past thirteen weeks.

These were the major changes in accounts over the past thirteen weeks. Other smaller movements of funds provided the balance of getting to the $2.0 billion decline in the Reserve Balances account.

Over all, excess reserves in the commercial banking system declined by about $2.2 billion from the first week in September to the first week in December. Thus, the initial move toward quantitative easing has not resulted in any major change in the banking system, although the Fed’s balance sheet rose by about $45 billion, to almost $2.4 trillion. This rise has occurred due to “operating transactions” relating to the seasonal rise in currency outside of commercial banks and due to the recapitalization of AIG.

So far, the major impact of the QE2 formula is the shift in the overall portfolio of securities held outright by the Federal Reserve. Here we got a major shift from mortgage-backed securities and Federal agency securities to securities issued by the United States Treasury.

We will keep watching.

One final point: I have never seen the Federal Reserve so blatantly political. Fed Chairman Ben Bernanke is now the “point person” for the Obama administration’s economic policy. Never, has a Fed chairman had to go out and sell the government’s monetary and fiscal policy like Bubble Ben has. To me, it’s embarrassing. As reported by Mike Allen in Politico Playbook, the FEDWATCH On 60 MINUTES - CBS News release: “In a rare and frank interview, Federal Reserve Chairman Ben Bernanke talks to Scott Pelley about the troubled economy and the measures the central bank has taken to improve it. Bernanke's interview took place in Columbus, Ohio, last Tuesday (30) and addresses several pressing economic matters..He also talks about the federal deficit and reforming the tax code. He explains why the Fed announced its intention to buy $600 billion in Treasury securities, defending against charges the move will lead to inflation and not ruling out the purchase of more. The Fed chair also addressed the federal deficit.”

Friday, December 3, 2010

Step on the Gas; Hit the Brakes; and at the same time!

There has been lots of words and press spilled on the recent revelations about who the Federal Reserve “bailed out” during the recent financial crisis. Let me just use one such article to capture some of the attitudes being expressed about this information.

Sebastian Mallaby, a senior fellow at the Council on Foreign Relations and the author of the book “More Money than God”, writes in the Financial Times” (

“The point is that the Fed bail-outs were hair-raisingly enormous, and that neither the regulators nor the regulated should be allowed to forget that. Wall Street institutions that now walk tall again survived only because the taxpayers saved them. Goldman Sachs turned to the Fed for funding on 84 occasions, and Morgan Stanley did so 212 times; Blackrock, Fidelity, Dreyfus, GE Capital – all of these depended on taxpayer backstops. The message from this data dump is that, two years ago, these too-big-to-fail behemoths drove the world to the brink of a 1930s-style disaster – and that, if regulators don’t break them up or otherwise restrain them, they may do worse next time.”

There doesn’t seem to be much movement afoot to “break them up” at this time, but there has been, and will continue to be, great efforts to “restrain them”. I don’t see the will or the leadership to “break them up”. I have my own views about the ability of the government to “restrain them” but I treat that question elsewhere.

I would like to raise another issue at this time which I believe to be integral to the situation mentioned above.

Discussions about the actions of the Federal Reserve during the financial crisis tend to be completely void of any discussion about the actions of the federal government or the Federal Reserve in creating the environment that resulted in the financial collapse.

Leading up to the financial crisis of 2008-2009 was approximated fifty years of governmental actions that created the largest credit inflation in the history of the United States. The gross federal debt of the United States government increased at a compound rate of approximately 9 percent per year from 1961 to the start of the crisis. Monetary policy, throughout this time period, accommodated this growth in debt. And, this period saw the greatest burst of financial innovation and credit creation in world history.

Why did this happen?

Two major reasons: first, the short-run emphasis of the government to sustain high, perhaps unsustainable, levels of employment; second, the goal of the government to put as many Americans in their own home and provide them with a financial “piggybank” to secure their future.

The first reason meant that the government had to keep stimulating the economy to keep people employed in the jobs they had. As a consequence, many American workers did not have the incentive to grow and prepare themselves for the “jobs of the future.” As a consequence, about one out of every four Americans of employment age is “under-employed”! Furthermore, the length of being unemployed has trended upwards from the 1950s and in October 2010 the average duration of unemployment is just about 34 weeks, almost three years. (See “Unemployed and Likely to Stay That Way,”

The second reason meant that the government had to build programs and provide financial innovation and finance so that more people could own their own homes. The inflation that took place in the real estate sector resulted in home ownership becoming the real “piggybank” of the middle class, producing for them the “best” investment they could experience over this time until, of course, the bubble burst.

The federal government set up the environment and the incentives that everyone else had to live within.

Chuck Prince, the former Chairman and CEO of Citigroup, made the now famous statement that “while the music keeps playing, you must keep dancing.”

The environment created by a government that set the example of “living beyond one’s means” created an almost perfect environment for taking financial risk, mismatching maturities, leveraging up debt, and financial innovation. The “Greenspan Put” during the 1990s and early 2000s sustained this environment by providing downside protection thereby creating greater “moral hazard.” In essence, the federal government “kept the music playing” and businesses, both financial and non-financial, had to “keep dancing” in order to remain competitive.

The question was constantly asked by executives, “How can I get a few more basis points return to be competitive with others in the industry?” The answer within such an environment was more leverage, more risk, and new financial innovations. At least, until the load became too heavy to bear.

But, in the rush to “break” companies up or to regulate and “restrain” them from such activity, most people have forgotten that the whole environment and the incentives set up were created by the same people now interested in breaking up these companies or restraining them.

So, within this call for breaking up these companies and regulating them more closely we hear
the same people calling for more government spending, more tax cuts, more quantitative easy on the part of the central bank, and greater welfare benefits to those that are hurting.

This is why the whole scenario seems to be one of trying to drive your car as fast as you can while at the same time trying to drive your car as safely as possible.

You are stepping on the gas and stepping on the car brakes at the same time!

So, where does this discussion take us? Really nowhere.

In my view, the people calling for the federal government to constantly provide fiscal and monetary stimulus to the economy are still in control and I don’t see their demise anytime soon.
People will try to regulate and restrain the financial sector, but, as I have written many times before, they will not be able to be successful. Given the global nature of finance today and the tools brought to the finance industry by information technology, these attempts to regulate and restrain will not succeed.

And, there will be renewed calls for providing social services and payments for those being hurt by the actions mentioned in the preceding two paragraphs. What is really needed to resolve the problems of the modern economy is of a long term nature and our short-sighted politicians will never implement these solutions, at least, anytime soon.

So, we must continue to face a bumpy ride. Stepping on the gas and the brake pedal at the same time produces such a ride.

Wednesday, December 1, 2010

More Stress Tests Coming for the Banks of Europe

We have been given Quantitative Easing 2 (QE2) by the Federal Reserve System in the United States and now we are facing Stress Tests II (ST2) to be imposed on banking institutions in the European Union. (

Will we eventually be facing Financial Reform Act II (FR2) that will incorporate the next round of regulatory reforms of the financial system of the United States?

I put this new round of stress tests for banks in the same place I put QE2 and the initial Financial Reform Act of 2010 and Basel III (B3)…in the dust bin. For my comments on QE2 see; for my comments on the Financial Reform Act see; and for my comments on B3 see

Regulators and reformers (R&R) just never seem to get it right!

One reason is that they are always fighting the last war. The current popular belief amongst the R&R is that the initial stress tests in Europe did not include tests on liquidity and this element of the banking structure needs to be examined to get a real view of how much “stress” the banks can take. The R&R intend to correct this omission in the next round of stress tests.

Just two points on this. First, liquidity is a market condition and not something that exists on balance sheets. One cannot look at a balance sheet and determine how liquid markets will be. Duh!

Second, if a bank cannot raise funds in financial markets because they have bad assets, this is a solvency problem and not a liquidity problem. In addition they cannot retain funds from market savvy customers

Hugo Dixon wrote in the New York Times yesterday that the Irish banks, Allied Irish Banks and the Bank of Ireland, were “excessively dependent on wholesale money from other banks and big investors.” These monies are very interest rate sensitive and very sensitive to credit risk. Even though these banks passed the earlier stress tests, when the smell of problems arose, the wholesale money “started to flee.”

However, the problem faced by these banks was not a liquidity problem. The problem arose because the wholesale depositors were concerned over the health of the banks and this is a solvency problem.

The situation here is that the R&R can only work with historical data and, consequently, are always behind the times. Their analysis is always static. The movement of the “wholesale money” is current market information and provides a forward looking assessment of the condition of a bank or banks .

What would be desirable would be current information that was “forward looking” and more accessible to the investing public. What would be desirable would be some kind of “forward looking” market information that reflected the viewpoint of market participants that were “betting” their own money.

In a recent post I included a chart that presented market information and was very current. (See This chart shows information on Credit Default Swap (CDS) spreads on European banks as well as on Spanish banks. One can see that the price of these CDSs began rising in late 2009 in anticipation of the sovereign debt crisis of 2010 and began rising even more dramatically before the current crisis that Europe is now facing. It seems as if some market indicator like these CDS’s could be used as an early warning signal that trouble was brewing in the financial sector of an economy or in specific banks.

Note, that the information provided by the Credit Default Swaps could be used as an early warning signal that something was wrong and this “signal” could then set off further analysis of the institution, or institutions, involved that would be conducted by the regulatory agencies.

Just such a suggestion has been made by Oliver Hart is the Andrew E. Furer Professor of Economics at Harvard University. Luigi Zingales is the Robert C. McCormack Professor of Entrepreneurship and Finance at the University of Chicago, Booth School of Business. Two references to their work are “Curbing Risk on Wall Street,”, and “To Regulate the Finance, Try the Market,”

To quote from the latter article: “In our mechanism, when the CDS price rises above a critical value (indicating that the institution has reached an unacceptable threshold of weakness), the regulator would force the LFI (large financial institution) to issue equity until the CDS price and risk of failure came back down. If the LFI fails to do this within a predetermined period of time, the regulator will take over.”

In the former article the authors argue that “The financial crisis of 2008 resulted from a series of misguided policies, failures of regulation, and missed signals. Unfortunately, much of the conversation about regulatory reform since has revolved around ideas that would only extend and exacerbate all three.”

The problem with implementing a plan like this is it that it causes the R&R to feel like they are losing some of their control…their power. Furthermore, many people within the R&R have little confidence in financial markets…it does not fit within their worldview. This is why I ended up a recent post with this comment: “many politicians and certain economists don’t like the market system. Market performance often contradicts the world views held by these politicians and economists. And, that makes them angry”

In conclusion, I have very little confidence in a new round of stress tests and believe that ST2 will lead to ST3…and then ST4…and eventually ST(n) where n is any number you want to give it. To me the sign that an approach is not appropriate and will not be successful over time is that people continue to use the same system and attempt to make the system tougher and tougher. Their system never works because their worldview needs to be changed.