Sovereign Recovery Swaps? What Are They?

 Sovereign recovery swaps are “bets on how much money will be retrieved in a default.”  The first trades took place last year.  (See “Default risks spark interest in recovery swaps trading,” http://www.ft.com/cms/s/0/0ab272c8-702e-11e0-bea7-00144feabdc0.html#axzz1KivknddC.)

Why did sovereign recovery swaps arise?

They arose as “European policymakers have moved to curb trading of credit default swaps, the established way to hedge against the risk of a debt restructuring.” 

These new tools are gaining more publicity as the eurozone moves back into a crisis mode concerning the sovereign debt of their troubled constituents.  This is especially coming to the fore as Greece struggles over its failure to achieve fiscal targets set to combat earlier financial market unease. 

Greek debt reached euro-era high interest rates yesterday…as did the interest cost of Ireland and Portugal debt. 

Calls are increasing for a restructure of the debt of Greece.

So, financial market participants want a way to protect themselves against unfavorable movements in debt prices…given the wisdom of “policymakers” to curb trading in other instruments that might do the same thing.

With recovery swaps, an investor can bet on the level of “haircut” that might take place on any restructuring. 

A credit default swap might have a fixed recovery rate in the case of a restructuring.  If the recovery rate is lower than this fixed rate, the investor makes up the shortfall through the purchase of the recovery swap. 

Of course, there are risks associated with these tools: the “credit event” that triggers the contract must be due to a failure of the nation to meet obligations…it must be an “official” default.

The point I want to emphasize, however, is how quickly financial markets respond to fill a need when restrictions or potential restrictions are devised to restrict or constrain other means of achieving the same objective. 

Policymakers just don’t get it! 

In their efforts to fight “past wars”, policymakers invent new rules or regulations to combat behavior the policymakers deem to be inappropriate or unacceptable.  In doing so, these policymakers just chase the participants in financial markets to move elsewhere or to create new financial innovations.

Two points here:

First, in this electronic age, there is little that regulators can do to establish the “control” that they want because it is so easy for one form of “information” to be transformed into another form;

And, second, once financial innovation is in place, there is no going back to an earlier time.

Policymakers just don’t seem to understand these two points.

Furthermore, another fear that the policymakers have is that these financial innovations can be used for “speculation”. 

For example, when the government of Greece announced its latest budget results, the cost of borrowing immediately went up and the price of credit default swaps and sovereign recovery swaps rose.  Some government officials claimed that unconscionable speculators betting against the government caused these movements. 

This, of course, is the basic visceral response of leaders faced by market movements unfavorable to the direction they are leading their organization.  I don’t know how many chairman I have known or worked for that have claimed that ‘the market just doesn’t understand us” and “speculators are hitting us just when we are down.”

I was less worried the other day when Standard & Poor’s said that the outlook for the debt of the United States was negative than I was about the response of President Obama saying that the bond markets were being impacted by speculators.  Oh, my!

Policymakers must eventually deal with the problems they have created.  Many governments in Europe have been dealing with the problems they have created for many months now, yet have not faced their real issues head-on. 

Policymakers must eventually realize that they cannot resolve these problems by changing the rules and regulations or by trying to buy time with “quick-fix” bandages.  The eurozone has been attempting to “get around” the solution to the problems of its members with short-term “fixes” and have not dealt with the fundamentals of the situation.

Policymakers must eventually understand that in the modern world information spreads and that governments cannot respond to crisis by pointing the finger in another direction, blaming “speculators” or “terrorists” or some other agent that is questioning their leadership.  The governments of the eurozone must ultimately take responsibility for their actions and do something about it.

Keep your eye on markets and market innovations.  Don’t impose your own view on these market changes but dig as deeply as you need to in order to determine what the market is trying to tell you.  The markets may not always be right, but they do contain information we need to consider in making our own decisions.

The news today…there is going to have to be a debt restructuring within the eurozone.  Financial “band-aids”, government bailouts, and new rules and restrictions are not going to do the job.  Will it be Greece…or will it include Ireland?  Will it extend to Portugal…and then to Spain?  And, maybe others will be impacted as well?

The betting is getting hotter!

Large Foreign-Related Banks Now Hold $776 Billion in Cash Assets!

On February 21, 2011, I asked the question, “Why is most of the Fed’s QE2 cash going to foreign-related banking institutions?” (http://seekingalpha.com/article/254004-why-is-most-of-the-fed-s-qe2-cash-going-to-foreign-related-banking-institutions)

At that time, foreign-related banking institutions held $538 billion in cash assets. This was up $177 billion from the end of 2010.

This was so startling because large domestically chartered commercial banks in the United States held only $486 billion in cash assets. Yet, this number was up only $72 billion from the end of last year.

Here we are at the end of April and these same foreign-related banking institutions have increased their cash hoards by another $238 billion to $776 billion.

Note that since the end of 2010, the Federal Reserve has only increased the total cash assets in the banking system by $283 billion so that almost two-thirds of the QE2 money ended up at foreign banks!

The increase since then has been $250 billion of which 95 percent of the Fed’s injections have ended up in foreign banks!

What is going on here?

And what seems to be the major movement on the other side of the balance sheet?

Well, on December 29, 2010, these foreign-related banks had a negative $420 billion in an account called “Net due to related foreign offices.” Since this was a negative it serves basically as an asset. This is the amount owed foreign-related banks in the United States from their foreign offices.

On April 13, 2011, these foreign-related banks had a positive $7 billion in this account, so that the account moved $427 billion from an asset to a liability to these foreign offices.

In other words, it seems as if a bank asset was paid down to the point that the offices of these foreign-related financial institutions now came to “owe” their foreign offices.

What offset this $427 billion movement of funds from America to offshore accounts?

It looks a lot like the $415 billion increase in cash assets.

Is this what QE2 has succeeded in doing? Is QE2 getting transferred directly into foreign-related banking institutions and then getting transferred offshore?

Sure looks like it. The evidence is in the Fed’s own statistics.

No wonder that bank loans in the United States have failed to increase. No wonder the banking industry is not contributing to a stronger economic recovery.

Does a Declining Value of the US Dollar Reduce the Balance of Payments Deficit?

This blog was begun in February 2009. From the very beginning, I have been a “weak dollar” person, believing that the longer-term trend in the value of the dollar is downwards.

My reasoning for this is that the underlying economic philosophy of the United States government has generally been one of credit inflation in order to achieve rapid economic growth and low rates of unemployment and that this has been the case since 1961. And, my belief is that this economic philosophy has permeated both political parties, Republican and Democrat, so that the blame lies with “us” and not with a specific political party.

A consequence of this has been an 85 percent deterioration in the purchasing power of the dollar over this fifty-year period.

And, over this fifty-year period, the value of the dollar has declined by 35 percent against the currencies of major trading partners and more than 35 percent against many other currencies.

Many readers of this blog continue to argue that a decline in the value of the dollar is good because it helps the United States to achieve a lower balance of payments deficit since a decline in the value of the dollar will help us export more goods to other countries and will help reduce imports into the United States.

Floyd Norris has given us an article in the New York Times, “Euro Benefits Germany More Than Others in Zone,” that is important for us to consider. (http://www.nytimes.com/2011/04/23/business/global/23charts.html?_r=1&ref=business) In this article, Norris discusses how Germany has gained in “competitiveness” relative to other eurozone countries since the creation of the Euro. The point of the article is that as Germany gained in competitiveness, it’s balance of payments went from a deficit in 1999 to a surplus by 2002, with the surplus growing from there. Other eurozone nations have experienced just the opposite movement.

The competitiveness of a nation “is based on currency movements and changes in unit labor costs in major industrialized countries” Norris writes.

“German competitiveness against the rest of the world was probably helped by the fact that the relatively poor performance of other members of the eurozone held down the appreciation of the euro against other countries.”

Because of this, the other countries in the eurozone “lost competitiveness because unit labor costs have risen more rapidly in those countries. Absent the euro, many of the countries probably would have devalued their national currencies, but that is not possible as long as they remain in the eurozone.”

In effect, credit inflation plagued the other nations in the eurozone while Germany maintained its fiscal discipline keeping a constraint on unit labor costs.

Due to the loss of competitiveness, the balance of payments in these other countries either turned negative or became more negative.

I believe that the leaders of the United States should learn from this experience. To me, the United States has lost competitiveness relative to the rest of the world over then last fifty years. This loss of competitiveness has resulted in an increase in the balance of payments deficit carried by the United States, in spite of the falling value of the United States dollar.

Thus, since the dollar was floated in 1971, the value of the dollar against major currencies has declined by 35 percent. But, the United States lost the surplus it had in its balance of payments and moved into a deficit position in the early1980s. It was almost balanced around 1991 but then the deficit grew throughout the rest of the 1990s reaching its lowest point around 2007. Throughout this time, the declining value of the dollar did not seem to help correct the movement of the balance of payments into deficit territory.

And, I continue to believe that nothing has changed on the economic front. Both political parties in the United States continue to work out of the same playbook…regardless of all the rhetoric.

By focusing just on economic growth and low unemployment, the United States has worked its way into a very uncomfortable situation domestically, internationally, and with respect to the responsibilities it assumed in providing the world’s reserve currency.

As long as the leaders of the United States keep their eyes on the level of unemployment and economic growth and fail to appreciate the role that the value of the United States dollar plays in the overall strength of the country, the United States will continue to decline in international competitiveness and will continue to see the value of the United States dollar decline.

I know the United States is a world leader in many, many areas of the economic spectrum. Yet, the markets tell us a different story when it comes to the aggregate position of the United States in the world.

Yes, the United States is Number One…but, the value of the dollar has declined over the past fifty years, the bargaining position of the United States has arguably declined in world trade circles and more and more concern is raised over the use of the dollar as the world’s reserve currency.

What are the markets telling us? And, not just the short-run movements in the market but the general trends we see?

I believe that the world is telling us that we are fundamentally undisciplined, in our lives and in our finances. We innovate and are among the best at it. We have many of the best educational institutions in the world. There is so much that is good in the United States.

Yet, we live beyond our means and we take advantage of the privilege of having the world’s reserve currency to postpone the day when our debts come due.

There are some goals a government can achieve in terms of the economic policies it follows. Pushing higher rates of economic growth than the economy can attain does not seem to be one of these things. The United States economy has grown at a compound rate of growth of 3.1 percent for the last fifty years. The variance in this growth, on a longer-term basis, is very narrow. We do not seem to be able to grow much in excess of 3.0 percent over the long run, regardless of what we do.

In terms of achieving high levels of employment, low levels of unemployment, the record is not very good at all. In fact the variation in the unemployment rate over the past fifty years is quite high and the growth in under-employment over this time period is substantial.

But, the United States government has been very good in achieving a high rate of growth in its debt, the basis of credit inflation. The compound rate of growth of the public debt over the past fifty years has averaged around 9.0 percent per year. As a consequence, our overall competitiveness as a nation has declined and the balance of payments has remained substantially in deficit territory in spite of the substantial decline in the value of the United States dollar over this time period. You can point out all the areas you want in which the United States is a leader. The dollar continues to decline and our balance of payments fails to improve.

Here Comes the Chinese Yuan

What evidence have I got that the United States has mis-used its responsibility as the provider of the reserve currency of the world?

Look at the morning papers.

“Singapore Aims to be Renminbi Trade Hub,” in the Financial Times (http://www.ft.com/cms/s/0/64bac520-6a4f-11e0-a464-00144feab49a.html#axzz1JsjXsOj5).

“China Speeds Yuan Push,” in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052748704740204576272802457892870.html?mod=ITP_pageone_0&mg=reno-wsj)

In the first article we learn that Singapore has moved to become the first overseas center for trading the renminbi.  It was learned that Beijing will designate a Chinese bank to clear renminbi trades thereby allowing banks in Singapore direct access to the Chinese currency. 

In the second article we learn that China’s central bank is changing its rules so as to make it easier to bring funds raised offshore back onto the Chinese mainland.  This would mean that companies and governments could fund bonds and the purchase of goods in Hong Kong and the Chinese could move those monies around both into China and out to the rest of the world.

Although there seems to be no rush to make the Chinese currency fully convertible into other currencies, most analysts see this as just another step toward the Chinese currency playing a larger and larger role in world trade and finance. 

In the Financial Times article the authors claim that “The People’s Bank of China is pushing for a greater role for the renminbi in global trade and investment to reduce China’s almost total reliance on the US dollar.”

As is typical of Chinese strategy, there is no real hurry to achieve full convertibility and global position for their currency.  The move is slow and steady, building toward inevitability.  We need to remember this as the slow, patient, ascension of China proceeds in the twenty-first century.

No other country has really threatened the position of the United States dollar as a reserve currency since World War II.  This has been of great benefit to the United States and has allowed the US government to get away with a lot of things in international financial markets that it could not have done if it had not had the world’s reserve currency. 

Still, the failure of the United States to act in a fully responsible way relative to its providing the world’s reserve currency seems to finally be catching up with it. 

Beginning in the 1960s, the United States government began fifty years of credit inflation.  The first victim of this prolificacy was the international gold standard, which ended on August 15, 1971 when president Richard Nixon announced that the value of the dollar would now be floated in the foreign exchange markets. 

The second victim was the purchasing power of the United States dollar.  A dollar that could purchase a dollar’s worth of goods and services in 1960 could only purchase about fifteen cents worth of goods and services in 2011.  That is, the purchasing power of the dollar declined by 85 percent during this fifty year time period!

The third victim was the value of the United States dollar in the foreign exchange markets.  Since the United States dollar was floated, the value of the dollar against the currencies of other major trading partners has declined by about 35 percent.  It has declined by even more against the currencies of other countries the US trades with. 

The United States has profited greatly over the past fifty years or so by having its currency serve as the reserve currency of the world.  Treasury Secretary Geithner drew on this fact the other day when he claimed that the world was still very comfortable buying US Treasury securities. 

Yet the confidence of the world Geithner claimed for the purchase of US Treasury securities is sadly tarnished by the performance of the United States dollar in world foreign exchange markets.  The United States has benefitted from its position as the supplier of the reserve currency, but it has abused its responsibility of being the supplier of this reserve currency by following a path for fifty years of fiscal and monetary policy that undermined the value of the currency.

Now, there is a rising star in the world that threatens the position of the United States dollar.  As I remarked above, the Chinese currency still has a long way to go to dethrone the United States dollar.  What we must notice, however, is that the fault lines seem to be forming.

It will be interesting to see what the leaders of the United States government do as this situation becomes clearer. 

Why Invest in Commercial Banks?

 Why should anyone invest in commercial banks these days?

My answer is that they should not.

My reason for this is that bank accounting is so screwed up that it is extremely difficult, if not impossible, to place a value on the assets of a bank. 

Now, this is a broad ranging generalization and I know that there are banks who are open and transparent about the value of their assets, but…

A case in point: yesterday, Citigroup released its earnings for the first quarter.  Let’s look at the analysis of these earnings by Francesco Guerrera and Patrick Jenkins for the Financial Times (http://www.ft.com/cms/s/0/8c5fb104-69e0-11e0-89db-00144feab49a.html#axzz1JsjXsOj5).

In order to reduce the impact of the new capital rules, Basel III, Citi has put “up for sale a $12.7 billion portfolio of bad assets that were responsible for some of its huge losses during the financial crisis.”

“Citi said the assets, which are believed to include subprime loans, mortgage-backed securities and corporate bonds, carried a ‘disproportionately high’ risk weighting under the new capital rules…”

Hence the desire to get rid of the assets.

“Citi’s decision resulted in a $709 million pre-tax charge in the first quarter but enables it to take advantage of a recovery in the market for distressed assets and boost capital buffers…”

“Citi said it had already sold about three-quarters of the assets at prices above the levels at which it valued them on its balance sheet…”

But, this background information follows.

“In order to put the assets up for sale, Citi had to reverse an accounting maneuver performed during the crisis, when it moved them from its ‘trading’ book to it ‘banking’ book.”

“Such a shift, which mirrored moves by other commercial banks, helped Citi to avoid suffering quarterly mark-to-market losses on those assets at the height of the turmoil.”

“However, accounting rules require financial groups seeking to move assets back to their ‘trading’ book to show that the facts around their initial decision had significantly changed.”

“John Gerspack, Citi’s chief financial officer, said the company argued that Basel’s higher risk weightings constituted such a change.  Citi’s argument was accepted by the US Securities and Exchange Commission, potentially paving the way for other banks to follow suit.” 

“Several banks have shrunk their balance sheets and shuffled assets in order to cope with the rise in capital requirements demanded in the Basel III regime.  However, their efforts have taken place largely behind closed doors, with very few providing details of their plans.” 

How is an investor really to know what assets will be treated in which way at what time?

And, the question can be raised concerning the treatment of Citigroup or other large banks relative to other, smaller financial institutions.  Smaller banks don’t have the expertise or can’t hire the expertise or don’t really have the ability to maneuver their portfolios in such a way.

However, in many cases in which assets cannot be “re-classified”, asset values have not been written down because “hope” was expressed that many of these assets would improve in value once the economy began growing again.

The ‘hope’ may be wearing a little thin as some borrowers may be running out of time.  See my post “Commercial Bank Closures,” http://seekingalpha.com/article/264104-commercial-bank-closures-2-3-banks-per-week-in-2011.

The situation may be changing in other areas as well.  In some cases, the change is coming from the regulatory side.  Take the case of the rating agencies and the municipal bond market.  In January 2011, Standard & Poor’s cut the rating of DeKalb County, Georgia from triple A to double A and then reduced it to triple B.  Now, S & P has withdrawn rating from it at all. (See http://www.ft.com/cms/s/0/106b35da-69e2-11e0-89db-00144feab49a.html#axzz1JsjXsOj5.)

“Matt Fabian, managing director at Municipal Market Advisors, says one reason why rating agencies may be acting more aggressively with patchy disclosure is regulation.  New rules, set out in the Dodd-Frank Act, have been introduced after rating agencies came under fire for miscalculating risk in mortgage debt before the financial crisis.”

The question now becomes: If Dekalb County was rated triple A in January and currently is not rated at all, what other triple A rated entities…or even A rated entities…might face lower ratings in the near future?

How should these assets be valued on bank balance sheets?

Over the past forty years, too many tricks have been played with bank accounting and bank accounting standards. 

As readers of my blog know, I am a strong advocate of “mark-to-market” accounting.  Bank executives make decisions and they need to be held accountable for them.  If they take risks then they need to own up to the risks that they have taken.  Bank accounting must become straight-forward enough and open enough for people that want to invest in them to have sufficient information to value their assets. 

I would think that the regulators would want this as well.

I am tired of hearing stories like the one on Citigroup reported in the Financial Times.  And, new stories pop up all the time.  In terms of accounting and openness related to the books of banks, there seems to be no difference between the regulators and the banks. 

If we are to have a safer banking system I believe that this situation must end!

Commercial Banks Closures in 2011

The Federal Deposit Insurance Corporation oversaw the closing of six banks on Friday, April 15.  This brings the total for 2011 up to 34 banks, a pace of about 2.3 banks per week. 

In 2010, 157 banks were closed, a pace of about 3.0 banks per week.

The problem bank list published by the FDIC every quarter rested at just under 900 banks (out of 6,529 banks in the banking system) on December 31, 2010.  We are waiting for the release of this number for the March 31, 2011 date.

The other number that is important in this respect is the number of banks that were acquired or merged into other banks.  Last year there were 153 banks dropping out of the industry due to such consolidations. 

Thus, the number of banks in the commercial banking system declined by 310 units last year or at a rate of approximately 6.0 banks leaving the system per week.

Most of the banks dropping out of the banking system are smaller institutions.  However, last week a $3.0 billion bank was closed so it is not all just the very smallest banks that are leaving the system.  Still, it not the largest 25 commercial banks in the banking system, the banks that control almost 60% of the total assets of the industry, that are departing.

The question still remains about the health of this industry.  Is the number of problem banks in the industry going to remain around 900 institutions?  Are bank departures going to continue to run off at the rate of 5 to 6 banks a week?  Will these rates lessen this year?  Or, will they increase?

Supposedly, the condition of the smaller banks is getting better.  But, as we saw with Bank of America last week, the overhang of bad mortgage loans still plagues some institutions.  Right now, I believe that the drop off in foreclosures on residential mortgages is misleading because the whole foreclosure issue has become so political that we probably won’t really have a good idea about the situation in the housing industry and in loan writeoffs for some time. 

We do know, however, that there are a lot of commercial real estate loans coming due over the next twelve months and the word I hear about the refinancing of these loans is not good.  Vacancies in commercial properties remain high and cash flows have not picked up significantly.  Furthermore, as more and more political entities downsize, more and more office properties used by these state and local governments are being vacated.  This was not expected a year ago.

In addition, I am also hearing that more small- and medium-sized businesses have exhausted their efforts to re-structure and just cannot go on much further.  As their loans come due, they are informing their banks that they are not going to be able to pay off their loans and must re-finance.

Thus, the banks have to make a decision about whether or not they roll over the loans for another period of time.  Or, do they “bite the bullet” and say they just cannot keep the loan going with no real sign that things are going to get better.

Then there are the examiners looking closely over the shoulders of these bankers.  The regulators are still running scared and, given all the restructuring of the regulatory institutions, don’t want to have the people in the new regulatory alignment holding them accountable for being too easy on these “failing” banks.  There is enough finger-pointing going on with respect to the “lax” regulatory environment that existed in the past. 

Bankers, especially from the smaller banks, feel caught in the middle of this exercise.  They want to do what they can to help their customers survive.  Yet, they are being pressed by the regulators, who also feel they are under excessive pressure, to not show overly-optimistic hopes about the ability of these businesses to repay.   In fact, the result may be that a too pessimistic approach is taken toward the quality of the bank loans. 

As a consequence, we will probably see the list of problem banks remain somewhere around their current highs and we will probably see business loans and commercial real estate loans continue to decline on the balance sheets of the banking industry. 

And we will continue to experience a decline in the number of banking institutions in the United States. 

The crucial element of this decline is that it is that the decline takes place in an orderly fashion. 

I believe that the Federal Reserve has contributed greatly to the achievement of this orderly reduction in the number of commercial bans in the banking industry.  Keeping short-term interest rates so low and pumping so much liquidity into the banking industry has reduced what could have been a very chaotic evacuation into a relatively peaceful exodus. 

Of course, there are other consequences to the Fed’s policy and we will have to deal with those in the future.  For now, the Federal Reserve has kept the banking system open.

Until the history of the recent financial collapse is fully understood and written up, most of us will probably not know how serious the banking crisis has been.  We get bits and pieces of this seriousness, but government officials have not really believed that the depth of the problem should be presented to the rest of the world.

For example, buried in the column Global Insight by Tony Barber in the Financial Times this morning is this observation: “For the truth about the eurozone’s crisis…is that the rescues of Greece, Ireland and Portugal are at heart rescues of European banks…Restructuring these countries debts would involve losses for German banks…” (http://www.ft.com/cms/s/0/4ed1d54a-6915-11e0-9040-00144feab49a.html#axzz1JsjXsOj5).   But this is not what is expressed in most governmental commentary. 

It appears as if the credit inflation of the past fifty years in America, and in Europe, seriously infected the banks and the cure for this infection is taking a very long period of time to achieve and is creating, in the process, economic and financial dislocations that we may not fully recognize for many years. 

For now, however, we can only hope that the cure takes place in an orderly fashion. 

Have Things Changed in the United States Budget Debate?

Last week, April 7, 2011 to be exact, things started to change. Jean-Claude Trichet, President of the European Central Bank, guided the ECB to an increase in its policy interest rate, moving from 1.00 percent to 1.25 percent. (See http://seekingalpha.com/article/262429-trichet-delivers-ecb-hikes-its-interest-rate.)

The night before the announcement, Portugal declared that it would seek a bailout from the European Union.

Last Friday evening, President Obama, the United States Senate and the United States House of Representatives reached an eleventh-hour agreement on the 2011 fiscal budget.

Yesterday, President Obama gave a speech laying out his ideas about improving the fiscal position of the United States government in the upcoming future.

Has Trichet and the ECB provided the turning point?

It is not altogether clear that the financial markets believe that the real attitudes in the United States have changed. Since the Trichet announcement, and through the political maneuvering in the United States over the past week, the Euro rose from about $1.42 per Euro to about $1.46 per Euro. Op-ed pieces in the Financial Times have argued that the Americans are really not serious about getting the budget under control. Seems as if people are not convinced yet that there is anyone in the American government that is intent upon really doing something about the situation. They are just posturing.

And, there is one person I have not mentioned that plays a vital role in this scenario: Ben Bernanke.

Bernanke in now on the opposite side of the picture from Trichet. (http://seekingalpha.com/article/261863-the-euro-trichet-vs-bernanke)

Trichet has turned the corner and raised interest rates.

Bernanke continues to promote QE2.

The Europeans cannot fault the Americans for messy governance. Since the sovereign financial cookie began to crumble in Europe in January 2010, the governments in Europe have fallen all over themselves trying to avoid any real fiscal action that would restore order to the national problems of the continent.

This has allowed countries to delay taking real actions that might resolve the European situation.

Then Trichet stepped up. Because of the pending ECB movement, Portugal had to move, they had to show some activity before the rate increase was announced.

Now, other European nations are on notice. Trichet has indicated that the recent move was not necessarily a part of multiple moves in the interest rate. But, I don’t think that any European nation doubts that Trichet and the ECB will continue to raise rates if the troubled nations don’t seriously attack their problems.

As I said, Bernanke is on the opposite side of the picture.

The Bernanke record? Before the Jackson Hole speech in late August (http://seekingalpha.com/article/222704-bernanke-in-the-hole), a Euro could be purchased for about $1.27. By early November, the price of a Euro had climbed to about $1.42. Into January, as the governments of the European Union messed around, this price dropped to around $1.30. Trichet started making noises that maybe the ECB needed to start raising interest rates and this resulted in value of the Euro rising again to around $1.40. And, Bernanke continued to defend the Fed’s quantitative easing!

What is Bernanke holding out for? What does he know about the economy or the banking system we don’t?

Of course, Bernanke has always been late to the dance. He was still promoting excessively low interest rates in the early 2000s when the housing bubble and the stock market bubble were accelerating. He was still fighting inflation in August 2007 as the regime of the Quants broke. He was still worried about inflation in August of 2008 until he wasn’t worried about inflation in September 2010. (See http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic)

Any bets that Bernanke will be late to the party once again?

But, when it comes to the lack of confidence in the will of the United States to support the value of the dollar, Bernanke is not alone. With two exceptions, the United States government has followed a policy of credit inflation for the last fifty years that has resulted in a decline in the value of the dollar against major trading partners of around 35 percent. The value of the dollar has declined against other, non-major trading partners, by even more than 35 percent over this time period.

The two exceptions came when the monetary policy of the United States was led by Paul Volcker, 1979-1987, and the fiscal policy was led by Robert Rubin, 1995-1999. During these periods the value of the United States dollar rose strongly. Yet, overall, the value of the dollar still declined by 35 percent.

And, the United States dollar is the reserve currency of the world. We should be really proud of having this responsibility. And, in carrying out this responsibility the economic policy of the United States government has caused other sovereign nations to lose part of their wealth due to the fact that the United States was inflating their currency and causing a decline in the value of the currency reserves these nations were holding.

For the near term, Bernanke is going to “stay with the fight”. That is quantitative easing is going to be continued through June. Between now and then the “debt ceiling” fight is going to heat up along with the competition now being billed as the “budget debate.”

And, the value of the United States dollar will continue to decline (baring other shocks to the world).

The value of the United States dollar will continue to decline over time as long as the rest of the world believes that we will not get our fiscal house in order and also believes that our central bank will continue to inflate the globe!

How will we know if the rest of the world begins to take our fiscal and monetary responsibilities seriously?
We will know that attitudes have shifted once we begin to see the value of the dollar firm up and even begin to rise on information about growing discipline over the budget and monetary policy. (I have written an Instablog on this: see “What is Needed to Reduce the Federal Deficit,” March 3, http://seekingalpha.com/author/john-m-mason/instablog.)

For now, we hear a lot of platitudes in the budget debate but very little noise of rubber hitting the road. We have a right to remain skeptical.

The Smaller Banks and Rising Interest Rates

The “sure” bet over the past year or so has been that the Federal Reserve would keep short term interest rates as low as they could for a long time.

In fact, the Fed told us they would keep short term interest rates low for “an extended period” of time, guaranteeing speculative bets on interest rates.

Long term interest rates have also been “low” during this time as liquidity splashed over from the shorter end of the financial markets to the longer end.

However, the spread between long term interest rates and short term interest rates have been very, very nice for a lot of investors and certainly, the bank regulators have not been displeased by the interest rate spreads that have been available to investors, particularly commercial banks and other financial intermediaries who have been able to build up profits to strengthen their institutions.

This spread has been nice for profits but this was not exactly all that the Federal Reserve wanted throughout this period of quantitative easing. In fact, the Fed was very clear that one of the main reasons it was engaged in quantitative easing was that by flooding the financial markets with liquidity, longer term assets, which under other circumstances proved to be very illiquid, could be disposed of when the markets were in a much more fluid situation. The banks were supposed to sell off a lot of their long-term or less-liquid long-term securities.

Furthermore, this would ease the pressure of “mark-to-market” accounting on the banks since such sales at prices closer to purchase value would allow the banks to escape the need to write down other, similar assets even though there was no intent on the part of the banks to sell the securities in the near term.

The larger commercial banks in the system took advantage of this interest rate spread in the earlier stages of the recovery to generate healthy profits and get themselves back on the way to greater solvency, with reduced regulatory oversight.

Then, the larger banks moved on to other things, once the regulators backed off and government money was repaid. The biggest banks are not nearly as mismatched as they were two years ago.

In my opinion, the interest rate policy of the Federal Reserve did more to help the biggest banks regain their “mojo” than did any other part of the bailouts. The Fed’s policy was a grand subsidization program carried out under the cover of helping to get the economy moving again.

The smaller banks, however, have not prospered from the quantitative easing. The maturity mis-match has allowed these smaller organizations to counter some of the enormous losses in commercial and residential mortgages they had to absorb.

But, offsetting these loses did not get the smaller banks back to a robust profitability and, since it was the only game in town, did not allow these banks to deleverage their balance sheets in the way that the larger banks did.

It was the “only game in town” because this maturity arbitrage was profitable, whereas the banks had a lot of bad assets to work out, and making new bank loans, in many markets, were either difficult in terms of finding credit-worthy borrowers or were not guaranteed profit-makers.

As we have seen, the smaller commercial banks in the United States have not been lenders over the last two years or so. Since July 2008, the smaller commercial banks have grown in asset size by about 5 percent, but the increases have come in cash assets and securities holdings. Interest rate arbitrage has been more important to them than initiating new loans, especially with so many existing loans to work out.

Total loans and leases at the smaller commercial banks peaked in February 2009, commercial and industrial (business) loans peaked in November 2008. Both of these categories have been on a downward trend ever since.

The smaller banks still suffer and continue to face the close scrutiny of the examiners in terms of their viability.

Thus, we are sitting on the edge of a rise in interest rates, both long- and short-term, and many of the smaller banks have not gotten out from under the cloud of the longer term assets they hold on their balance sheets.

Of course when interest rates begin to rise, short-term interest rates will rise faster than will longer-term rates and spreads will decline. But, with the specter of interest rates rising, selling long term securities will not be as easy as it has been to sell them over the past year or so.

The smaller commercial banks have benefitted over the past two years by the Fed’s policy of quantitative easing in the sense that they have been able to arbitrage long-term and short-term interest rates. It has provided earnings through the maturity mis-match and it has allowed the banks time to work out some of their assets, charging others off in an orderly fashion. But, this has resulted in few new loans.

As a consequence, the prospect for strong earnings in this sector is slim. The question then becomes, “What are the regulators going to do as the asset portfolios of these banks lose market value as interest rates rise?”

The Federal Reserve cannot continue to keep quantitative easing going, underwriting short term interest rates that are near zero! On this see my recent posts, http://seekingalpha.com/article/262788-fed-s-monetary-policy-cannot-be-conducted-in-isolation, and http://seekingalpha.com/article/262429-trichet-delivers-ecb-hikes-its-interest-rate.

Or, can it?

This would allow the smaller banks the opportunity to carry on with their interest rate arbitrage. However, what really needs to change for many of these smaller banks to survive the times is for real estate prices to rise enough so that the banks’ portfolios of residential loans and commercial real estate loans become solvent again.

We probably will get the rise in prices. But, will the rise really help the properties behind the banks’ problem loans?

The Small Banks Are Going Nowhere

Over the past six months or so the total assets of the smaller banks in the United States (smaller than the largest 25 banks) have remained relatively constant. Total assets averaged about $3.6 trillion in September 2010 and they averaged just below this number in March 2011.

And, given the Federal Reserve’s QE2 policy which has caused the cash assets of commercial banks in the United States to increase by almost $350 billion over this time period, the cash assets of these smaller banks remained roughly constant.

Over the past 13-week period, total assets at these smaller banks increased a modest $3 billion, but over the last 4-week span of time, total assets dropped by almost $10 billion.

Cash assets (over the past 13 weeks) rose by slightly more than $3 billion at a time when the total cash assets of the whole banking system were increasing by more than $480 billion.

The smaller commercial banking sector seems to be going nowhere.

What about credit extension amongst these banks?

Loans and leases at the smaller banks dropped by more than $8 billion over the last four weeks. The drop over the last thirteen weeks was slightly more than that.

And the largest 25 banks?

Total assets at the largest banks have increased by $60 billion over the past four weeks and by almost $90 billion over the last thirteen weeks. Most of the growth these largest institutions have come in cash assets. However, the increase in cash assets at the largest 25 banks in the United States has been small relative to the increase in the cash assets of foreign-related financial institutions in the United States. (See http://seekingalpha.com/article/262788-fed-s-monetary-policy-cannot-be-conducted-in-isolation.)

And, what about bank loans at these larger banks?

Since the end of 2010, loans and leases at commercial banks in the United States have declined by about $105 billion; and over the last four weeks of the first quarter, loans and leases at large commercial banks have declined by about $11 billion.

Business loans have rallied some over the last thirteen weeks, up a little more than $12 billion, but $10 billion of this increase has come in the last 4-week period.

Real estate loans have plummeted at commercial banks both over the last four weeks and the last thirteen weeks. The declines have come in both residential and commercial real estate loans.

And, what asset class, other than cash assets, has increased the most at the larger financial institutions? The securities portfolio.

So, the update on the banking industry as of the end of the first quarter of 2011?

The smaller banks, as a whole, continue to be in a holding pattern. And, QE2 seems to be doing little or nothing for these institutions. The cash reserves the Fed is pumping into the banking system is going to either the foreign-related financial institutions in the United States or the largest 25 commercial banks in the United States.

The smaller banks are not increasing their loan portfolios.

For the larger banks, QE2 is having some impact as cash reserves at the largest banks are increasing and the securities portfolios of these institutions are also increasing.

However, loans, as a whole, are not increasing…although there seems to have been a little pickup in the area of business loans.

Overall, one sees very little evidence that the Fed’s QE2 is having any impact on bank lending which, of course, does not provide much evidence that economic growth is going to begin accelerating in the near future.

Not very encouraging.

Almost One-Half of Cash Assets in Commercial Banks are Held by Foreign-Related Institutions

Check this out: on April 6, 2011, Commercial Bank Reserve Balances with Federal Reserve Banks totaled $1.503 trillion (Federal Reserve Release H.4.1); for the two weeks ending April 6, 2011, Excess Reserves at depository institutions in the United States averaged $1.431 trillion (Federal Reserve Release H.3); and on March 30, 2011 Cash Assets held by Commercial Banks in the United States were $1.558 trillion (Federal Reserve Release H.8).

All these measures of excess cash in the commercial banking system seem to center around $1.5 trillion.

The Federal Reserve also reports that on March 30, 2011 the cash assets held by Foreign-Related (banking) Institutions in the United States totaled $702 billion or right at 45 percent of the cash assets held by commercial banks in the United States on that date!

The Federal Reserve policy of Quantitative Easing (QE2) is supposed to spur on bank lending which, hopefully, will contribute to a faster growing economy and lower unemployment.

The published figures indicate that a very large portion of the funds the Fed is injecting into the economy is going into the “carry trade” and contributing to the spread of American liquidity throughout the world.

One rationale that has been given for the policy that the Fed has been following is that when commercial banks aren’t lending (that is, there is a liquidity trap), the Federal Reserve needs to inject as much liquidity into the banking system as possible until the banks begin to lend again. This is the essence of quantitative easing.

This rationale was developed by people who studied the history of the Great Depression. Milton Friedman contended that a central bank should follow such a policy when faced with a banking system that was not expanding the money stock. Professor Ben Bernanke also suggested that such a policy be followed.

However, in the current environment, there are two things that seem to be different from that earlier period. The first relates to the international mobility of capital: in the period around the 1930s nations did not support the free flow of capital throughout the world because the international financial system was based on the gold standard and foreign exchange rates fixed in terms of the price of gold.

Thus, with international capital flows constrained, it was argued that a country could keep a fixed foreign-exchange rate for its currency and conduct its economic policy independently of other countries, thereby allowing the country to focus on reducing unemployment to more acceptable levels. The policy prescription advocated by Friedman…and Bernanke…could, therefore, be followed within such a world without major foreign repercussions.

This is not the situation that exists now. Capital flows freely throughout the world.

The second factor is that there was no designated national currency that was designated as the “reserve currency” of the world. Thus, currencies were seen as either fixed in value or were allowed to freely float in foreign exchange markets. (I am not dealing with “dirty” floats and so forth at this time because they are related to currencies that are not designated as “reserve” currencies.)

And, since the United States dollar serves as the reserve currency of the world and, because of this, is the default currency when there is a “flight to quality” in world financial markets, the value of the dollar does not fall to the level that is needed to allow the Federal Reserve to conduct its monetary policy independently of all other nations.

The consequence is that the Federal Reserve is inflating the whole world!

It is great for the currency of a country to be the reserve currency of the world. However, being the reserve currency of the world carries with it responsibilities.

One of these responsibilities is that the United States cannot conduct its monetary policy independently of everyone else!

The value of the United States dollar is higher than it would be if it were not the reserve currency of the world. As a consequence, the behavior of the value of the United States dollar does not act exactly as if it were determined if it were a freely floating currency in the foreign exchange markets.

Therefore, the monetary policy of the Federal Reserve, given the free-flow of capital throughout the world, cannot be conducted in isolation.

We are seeing the result of this situation right before our eyes.

The Federal Reserve is pumping money like crazy into the commercial banking system. And, 45 percent of the money is ending up in foreign-related financial institutions.

This, I believe, is not what the Federal Reserve wanted.

This, I believe, is not what the people of the United States wants.

And, I believe, that this is not really what the rest of the world wants.

Still, QE2 continues, unabated.

"We Don't Expect Americans to Fight Temptation"

Suggested reading for today: Gillian Tett’s piece in the Financial Times, “ECB rate rise will spark new debate about US tightening.” (http://www.ft.com/cms/s/0/e40ec032-613b-11e0-ab25-00144feab49a.html#axzz1ImD5RZZn)

She quotes a senior Latin American official in attendance at the recent annual meeting of the Inter-American Development Bank: “We don’t expect Americans to fight temptation” when the United States government has to make tough monetary and fiscal decisions. The speaker, Tett states, ended this statement “with a hint of the disdain developed nations used to deploy when discussing the third world.”

A specific concern is that United States monetary policy is flooding the world with liquidity and, in doing so, causing dramatic increases in commodity prices and asset prices.

Many countries in Asia and Latin America have responded with controls and other attempts at protection to stem foreign money coming into their countries via the carry trade. Brazil just imposed another round of controls this week.

Of course, Federal Reserve officials, including Mr. Bernanke, claim that the problem is “out there.”

American “officials insist it is poor local policy and excess savings in the emerging markets and not cheap dollars that are creating bubbles.”

And, anyway, a decline in the value of the dollar is good for America because the falling value of the dollar will make American goods cheaper in world markets and will help to improve the trade balance. Christina Romer, former Chairperson of the President Obama’s Council of Economic Advisors, just reiterated this claim when interviewed on national television this week.

Funny, but the statistics don’t seem to support this claim. Since the dollar was floated on August 15, 1971, the value of the dollar has declined by about 35 percent and the United States balance of trade turned negative in the late 1970s and, on an annual basis, has not been close to achieving positive territory since.

History does not support the conclusion that the falling value of a currency will improve a country’s balance of trade when that country is experiencing a period of sustained credit inflation.

Something happens to the production of a country’s goods and services when it is going through a period of sustained credit inflation. The productivity of that country declines relative to those countries that are not experiencing as severe a period of credit inflation.

For one, a country experiencing a sustained period of credit inflation will shift resources, building up finance and financial services at the expense of manufacturing. For example, about 35 percent of the output of the United States in 1965 came from the manufacturing sector. Early in 2011 this figure dropped to less than 14 percent. Also, exposure to risk increases during periods of sustained credit inflation along with increasing financial leverage and financial innovation.

Furthermore, in the United States the industrial use of capital declined from over 90 percent of capacity around the middle of the 1960s to around 80 percent at the last peak of capacity utilization. Capacity utilization now stands around 75 percent. The under-employment of labor also increases during such times. My estimates place under-employment of the American worker at around one in five people of employment age. I believe that over the next year or two this figure will not decline, even in the face of declining un-employment because of the wave of mergers and acquisitions that are going to take place.

The assumption of the economist that “everything else will not change” in the face of a declining value of the dollar does not hold. Yes, the declining value of the dollar does make American goods cheaper in world markets, but this does not account for the changes in the structure of the American economy when credit inflation pervades the nation for a fifty-year period. In the American case, the changing structure of the American economy has not helped solve the balance of trade problem.

The view from the “rest-of-the-world” is that the United States is not going to change its viewpoint. The United States has been able to act the way it has because it has had the “reserve currency” of the world and has been big enough to absorb the international capital flows that have existed over the past fifty years.

But, the United States fiscal and monetary authorities are in a battle now which, given their views, will not allow them act any differently than they have over the past fifty years.

They argue that government spending must be maintained or increased in order to put people back to work.

They argue that credit inflation must be forced on the American people so that the efforts of individuals and businesses to deleverage, to reduce the excessive leverage they had built in the past, can be offset and these individuals and businesses can get back to the process of re-leveraging so as to stimulate economic growth and reduce unemployment.

Ms. Tett speaks of the existence of the culture war between the European Central Bank and the Federal Reserve. Certainly, different worldviews seem to exist between the leaders of these two organizations.

But, it is the assumptions behind the worldviews that seem to be dramatically different and it is the assumptions that ultimately prove to be so important. The worldviews are derived from the assumptions, but it is the assumptions that people find so hard to give up because they become so personal.

As long as the United States continues to believe that the declining value of the dollar is good for the country, based on arguments similar to the ones attributed above to Christina Romer, and looks for excuses like “poor local policy” and “excess savings in emerging countries”, the leaders of the United States will continue to believe that it can proceed as it has for the last fifty years.

As long as the leaders of the United States continue to act as they have for the last fifty years then the value of the dollar will continue to decline.

And, the attitude toward American policymaking will continue to be: “We don’t expect Americans to fight temptation.”

Trichet Delivers: ECB Hikes Its Interest Rate!

The European Central Bank raised its policy interest rate by 25 basis points this morning and, I believe, changed the game.

Mr. Trichet, president of the ECB, delivered on his promise initiatlly given in March.

To me, this is a “tipping point”, even though the Bank of England kept its policy rate constant. Other central banks around the world have been raising their policy rates over the past year but no “Western” central bank had followed.

Now, the “West” has followed and this alters, not the outlook for interest rates, but the timing of future increases.

There are three areas one needs to focus on within the current environment.

First, keep an eye on what goes on in the Eurozone in terms of country “bailouts” and the potential re-structuring of the sovereign debt within the nations of Europe.

It was not a coincidence that Portugal asked for help the day before the meeting of the ECB. Portugal has lots of debt coming due this year; its credit rating has gone through several reductions already this year; and the country is without a government and facing an election. Even Portuguese banks were saying that they would not buy anymore debt issued by the government of Portugal.

Facing a “new” attitude in the capital markets and rising interest rates, what is substituting for a government in Portugal had to act. In essence, the IOUs were coming due.

And this means, I believe, that the IOUs are going to be collected elsewhere within the Eurozone. The day of reckoning has been advanced. People are going to have to do something now.

Second, watch what European banks are doing and are going to do. On Wednesday, two European banks announced their plans to raise new capital. The total to be raised amounts to about $19 billion and brings the total capital raisings announced this year by European banks to almost $36 billion.

Again, I don’t think that the timing of the announcement, the day before the ECB raised its interest rate, was a coincidence.

Furthermore, the Spanish government this week stepped up efforts to get its “healthy” banks to buy up a good portion of its “savings” banks in an effort to shore up Spain’s threatened banking industry. With Portugal now seeking help, a greater focus is going to be placed upon the fiscal health of the Spanish government and its banking system. Spain is going to move because it appears as if it may be “next in line”.

In addition, there still are the results of the recently applied “stress” tests on the commercial banks of Europe. Two things here: there is the question about how valid the tests are; and there is the response of the banks, themselves, to the results of the tests.

The European “stress” tests are already being questioned relative to whether they are strong enough to really be anything but a subject of jokes. If the tests are too weak to prove anything, then the credibility of the European regulators will suffer a serve blow at a very crucial time. This will not raise the financial markets confidence in the European banks and the European banking system.

The European banks may have to “act on their own” to overcome this loss of regulatory credibility. The way to do that? The banks can raise a significant amount of capital on their own and take the whole question of capital adequacy out of the hands of the regulators. This may be a part of the strategy of the European banks that are now raising capital.

Third, continue to observe the behavior of the United States dollar in foreign exchange markets. My guess is that this move by the ECB to raise its interest rate will cause further erosion of the value of the United States dollar in foreign exchange markets. This move may not be immediate, but will persist over time.

By raising its policy rate, the ECB may be forcing Europe to get its act together and resolve some of its solvency and governance issues. The movement by the Portuguese is just a starting point. The movement of the banks adds momentum to the process. If this action truly brings events “to a head” then, I believe, everyone will be better off for it.

But, if Europe begins to move in the right direction, what is in store for the United States dollar?

Europe moving to resolve some of its issues will only result in more pressure for the value of the United States dollar to decline. And, this decline will only provide additional evidence that the international community has little confidence in the current leadership of the United States to really address its fiscal (and monetary) problems.

The question then becomes…will this change the nature of the discussion within the United States?

Will this twenty-five basis point change in the policy interest rate of the European Central Bank serve as anaction that creates the “tipping point” for the direction of economic and fiscal policy in Europe and the United States?

I’m sure that the wiley Mr. Trichet would like to see this happen.

I’m not sure that the former professor of law from the University of Chicago and the former chairman of the Princeton Economics Department would agree.

The Dollar: America versus the World

I look at the following chart and ask whether or not there is some constant factor that stands behind the decline in the value of the dollar over the past fifty years.

Well, you say the chart only covers roughly forty years, why are you talking about fifty years?

You are right that the chart covers only the last forty years or so, but the consistency that runs from the early 1960s to the present began around fifty years ago.

The constant that runs throughout this time period is credit inflation. The foundation for this credit inflation was a “new” philosophy of the government’s program of fiscal policy, one that aimed at achieving high levels of employment. And, this new philosophy was essentially adopted by both the Republicans and Democrats in the United States government.

The consequences of this policy:

• The gross federal debt of the United States increased at a compound growth rate of about 8.0% per year for the last fifty years;

• Up until 2008, the Federal Reserve increased the monetary base at a compound rate of 6.2%;

• Total credit market debt in the United States increased at a compound rate of almost 10.0%.

• A dollar which could purchase $1.00 worth of goods and services in 1960 could only purchase $0.15 in 2011.

The credit inflation was started in the 1960s. It became such a problem that the United States floated its currency on August 15, 1971, and, with two exceptions, declined by about 35% against major currencies from early 1973 through March 2011. The two exceptions were the Volcker-led monetary tightening beginning in 1980 and the Rubin-led efforts to balance the federal budget around 1995.

One could argue that the credibility of the United States government for maintaining a stance of fiscal discipline, with these two exceptions, has been very, very low. And, that is the problem the United States finds itself in at the present: the behavior of the government, especially represented by Chairman Bernanke at the Federal Reserve, is seen as “just more of the same” economic policy that has been followed over the last fifty years. Consequently, the value of the dollar continues to decline.

In terms of the euro, Jean-Claude Trichet, the president of the European Central Bank, seems strong relative to Mr. Bernanke, and the value of the dollar continues to decline against the Euro. (http://seekingalpha.com/article/261863-the-euro-trichet-vs-bernanke)

It has been argued that Mr. Trichet and Mr. Bernanke have been working together during the recent financial crisis. That may be true, but coming out on this side of the crisis it looks to me like Mr. Trichet was the “craftier” of the two. Check out the chart below.

Beginning in September 2008 Mr. Bernanke began to inflate the Fed’s balance sheet. The total assets of the Fed jumped from about $0.9 trillion to $2.2 trillion. Mr. Trichet saw the total assets of the ECB increase, but the increase was far short of what the Federal Reserve did. (http://www.ft.com/cms/s/3/98ad43ec-5fac-11e0-a718-00144feab49a.html#axzz1IeD3XCmo)

Now the ECB may not have had as much to work with as the Fed, but in any case it looks as if Mr. Trichet got Mr. Bernanke to do most of the work for him through the crisis. (Check out the Fed’s recent release of borrower’s during the crisis and all the various comments that reflected on this release. There is some feeling that maybe Mr. Bernanke did not always act in the most disciplined way during this time period: http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

As a consequence, the current position of the ECB is much more conducive for Trichet to begin raising the Eurozone policy interest rate and, if needed, begin to focus more on the fact that inflation in the Eurozone is starting to become of concern once again.

The United States still faces the reality that, in terms of monetary and fiscal policy, there are no leaders who possess any credibility when it comes to budgetary discipline. This is the underlying constant of the past fifty years (with the two exceptions mentioned) and this is the basis for a continuing downward trend in the value of the United States dollar against other major currencies.

Paul Volcker has argued that the value of a nation’s currency is the most important price in its economy for policy purposes. It seems as if very few people agree with him. So, it seems as if the future will be more of what we got over the past fifty years. This is not what is needed for an economically strong America.

The Euro: Trichet versus Bernanke

How important is reputation in monetary circles?

I believe that the general movement in the value of the Euro relative to the United States dollar over the past seven months or so gives a picture of how the reputation of a central banker, when compared with his peers, can be reflected in financial markets.

The particular comparison here is between Jean-Claude Trichet, president of the European Central Bank (ECB), and Ben Bernanke, chairman of the Board of Governors of the Federal Reserve System. The winner has been Trichet; the loser Bernanke.

In general, the “bad” news has been coming out of Europe, the fiscal problems in Ireland, Greece, Portugal, Spain, and, if we want to get even more picky, Italy and France. The fiscal crisis really began to heat up at the beginning of 2010. The “crisis” caused another “flight to quality” in foreign exchange markets, that is a movement into the United States dollar and this is shown in the accompanying chart. The U.S./Euro Foreign Exchange Rate dropped early in 2010 and bottomed out in June as the European Union seemed to be getting its act in order.

Notice that the value of the Euro really begins to rise again in early September. This marks the time just after Chairman Bernanke announced to the world that the Federal Reserve was going to enter into another round of Quantitative Easing, now fondly referred to as QE2. (http://seekingalpha.com/article/222704-bernanke-in-the-hole)

The rise in the value of the Euro against the dollar was almost 12 percent throughout the fall.

Still the Europeans dawdled and the dollar strengthened again as money left Europe for “quality” assets.

Trichet took care of this after the March rate-setting meeting of the ECB. At that time he sent out strong signals that the ECB should raise its target interest rate at the April meeting.

So, after a decline of something less than 8 percent following the peak value reached in early December, the Euro has climbed another 9 percent or so, even in the face of continued concerns about the health of the banks in these countries and the revelations about the fiscal condition of some of the governments trying to get their budgets back in order. These concerns were accompanied by several downgrades of some sovereign European debt.

“As traders continued to bet the European Central Bank would pull the trigger on the first of several interest-rate increases on Thursday, the euro hit five-month highs against the dollar,” (http://professional.wsj.com/article/SB10001424052748703806304576242362812362214.html?mod=ITP_moneyandinvesting_3&mg=reno-wsj).

Thursday is the meeting of the ECB. The bets are obviously on the ECB raising its target interest rate.

Trichet has a credibility that Bernanke does not have. Trichet is standing up for some kind of monetary constraint. Bernanke keeps throwing spaghetti against the wall.

Trichet has moved ahead of events. Bernanke has always missed the turn of events and lagged sadly behind resulting in the need to over-react to situations.

But, this reflects the whole position in the United States. There is no one around that seems to have any credibility for establishing any financial or monetary discipline in the United States government. Why should anyone want to bet on the United States government establishing some kind of responsible budgeting when projections are for the government debt to increase by as much as $15 trillion over the next ten years? And, why should anyone want to bet on the Federal Reserve system controlling inflation during this time period when the leader of the central bank has injected $1.5 trillion dollars of excess reserves in the banking system and is always “late to the dance”?

The market is taking Trichet at his word. The market is also trusting his determination.

The United States? Maybe Paul Ryan, chairman of the budget committee of the United States House of Representatives, can build up some reputation in financial markets that someone in America is going to draw a “line in the sand.” Right now the financial markets are not betting on his success.

So for now, Trichet…and the Euro…seem to win.

The Health of the Banking Systems in Europe and the United States

What still bothers me is that governments in both the United States and Europe have not resolved their problems with the solvency of their banking systems.

The question remains about how long these problems are going to be carried along.

This morning we read, “Ireland’s Largest Banks Given Failing Grades.” It is assumed that the government is going to take over the banks and the price tag is going to be a minimum of about $35 billion. (http://professional.wsj.com/article/SB10001424052748703806304576234180828120692.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

Following up on this there is the article about the bank problems in Spain, “Spain May Take Over CAM as Deal Talks Fail.” Here again we have the possibility of nationalizing another bank. Moody’s Investors Service estimates that the minimum needed to get the Spanish savings banks adequately capitalized at between €40 billion to €60 billion. (http://professional.wsj.com/article/SB10001424052748703806304576234912073054934.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj)

On a smaller scale, we have another fiscal crisis in Portugal as it became known that the government’s financial figures were incorrect and that budget matters are worse than was expected. This news came a few days after Portugal’s credit rating had been downgraded once again. This, and the concern that Portugal may not be able to meet bond repayments falling in April and June, has raised new issues about the solvency of the Portuguese banking system.

In addition, we are still awaiting the results of the recently administered “stress tests” of European banks. There is substantial concern about what these “tests” might show.

And, question marks still hang over the health of the smaller banks…that is smaller than the biggest 25 commercial banks…in the United States banking system. The number of commercial banks on the FDIC’s list of problem banks was just under 900 on December 31, 2010. In all of 2010, 157 commercial banks failed while mergers occurred for 197 other banking organizations, many of them not exactly healthy.

This means that almost 12 percent of the commercial banks of the United States are on the problem list of the FDIC. Some put the number of commercial banks that are facing severe operating difficulties at 40 percent of the banking system.

I have argued that a major reason for the quantitative easing on the part of the Federal Reserve is to provide sufficient liquidity for the “smaller”, “troubled” commercial banks so that the FDIC can close or arrange mergers for as many of these banks as possible in an orderly fashion.

The concern over the health of the commercial banks in American and Europe is real.

And, now we are seeing just how extensive the financial crisis was in both Europe and the United States in 2008/2009. These banking systems collapsed together. And, the banking systems have continued to fail to resolve their issues together.

The release of the Federal Reserve statistics on borrowings from the Fed’s discount window, “Fed Kept Taps Open for Banks in Crisis”, is amazing in many respects. Some of the biggest borrowers, it turns out were from Europe. The Fed certainly became the worldwide “lender of last resort.” And, the Fed added large amounts of “junk” in the process. (http://professional.wsj.com/article/SB10001424052748704530204576235213193119194.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

The problems arose from real estate lending and the problems that continue are related to real estate lending.

The question that remains concerns the depths of the problems that still exist in the European and United States banking systems.

People I know are still in shock over the sale of the Wilmington Trust Company in early November 2010, a bank that everyone thought was in pristine shape. (http://seekingalpha.com/article/234027-wilmington-trust-sold-at-45-discount)

This subject came up again in discussions I was a part of during the past weekend.

The concern? How many more situations like that of the Wilmington Trust Company are there “out there”?

This is the worry that we cannot seem to shake.

And, the debate always seems to come back to one thing: Why is the Federal Reserve acting in the way it is? Injecting $1.5 trillion of excess reserves into the banking system does not make a lot of sense…unless the banking system is less solvent than we are being told.

There is a lot of discomfort… in both Europe and the United States…when it comes to looking at the banking system. Unfortunately, we may never understand how bad off the banks have been until we get more and more information in bits and pieces as things work themselves out.