Monday, January 31, 2011

Banking Keeps Changing: BankUnited and China's ICBC

There were two pieces of banking news last week that seemed to fall below the radar screen due to the visit of China’s President Hu Jintao and the events in Tunisia and Egypt. These two pieces of news had to do with BankUnited, a Florida bank that was “saved” by a group of buyout firms, and with ICBC, the world’s biggest bank by value which happens to be a Chinese bank, who announced that it was buying an American bank.

Bank United sold 29 million shares of stock at an initial public offering on Thursday evening for $27 per share. This put the value of the bank around $2.6 billion.

To me the important thing about BankUnited is the owners of the bank which include Wilbur L. Ross, Jr., the Blackstone Group, the Carlyle Group and Centerbridge Partners. BankUnited was Florida’s biggest bank when it failed in May 2009. The unique ownership of the bank came about when the FDIC sold the bank to this group of “private” investors.

The FDIC was “desperate” to attract capital and private-equity firms were where the money was. So the FDIC cut a deal with this group to “unload” BankUnited. This was a first because private-equity had never shown much interest in owning commercial banks…the returns were just not that great given the risks. And, the regulators never cared much for this kind of money…private-equity firms were only interested in a “quick” buck.

The deal for BankUnited was “rich” because the FDIC needed to unload the property. But, once one deal was cut, more followed, but they were not necessarily as “rich” as the first one. Now private-equity firms have acquired more than 50 banks.

The IPO on Thursday produced a lot of money for the owners. The owners are expected to take away more than $500 million from the offering and they still will maintain an ownership in the company of about 70%, more than $1.8 billion. The buyers put up $945 million to complete the deal with the FDIC.

The stock price rose almost 5% on Friday.

BankUnited is now highly capitalized, very profitable, is growing deposits, and also is making loans. And, management is now looking to buy other banks.

Commercial banking meets “Shadow” banking. But, this wasn’t the way it was supposed to be. Banks were supposed to get smaller because there was too much systemic risk when banks were too big to fail. Also, we had to go back to the “good ole days when banks were banks and other financial institutions were “other” financial institutions. But now we have private-equity firms owning more than 50 banks!

It seems like everything that the Obama administration and the regulators wanted has just been the opposite of what they have actually done.

In the decline in the number of banks which now exist, about 7,700, to less than 4,000 over the next several years, banks are going to continue to get bigger and the boundary between financial institutions and money sources are going to get more and more blurred.

Why? Well, for one, it pays, and it pays well. Second, there are just too many banks that need financial help and the Federal Reserve and the FDIC are going to do everything in their power (and maybe more) to make sure the weaker institutions are absorbed or consolidated into other organizations in as orderly a fashion as possible.

The second piece of news has to do with another foreign bank acquiring an American bank. This time, however, the foreign acquirer is Chinese: ICBC will acquire 80% of the Bank of East Asia’s retail branch system in New York and California. This acquisition must still be approved by United States regulators. If this deal is approved it will be the first time that a mainland bank in China would be operating under the regulatory framework of the United States. Up-to-now, American regulators have not approved the soundness of the Chinese banking system because it is government controlled and politically directed.

Although some wholesale business has been allowed in the past for Chinese banks, approval of this transaction would be entirely different because it would mean that the deposits of this bank would now be insured by the FDIC. Thus, the Chinese banks will not only have to open their books to the regulators, but it would also expose the Chinese regulators to scrutiny.

This acquisition will not alter the American banking landscape much in the near future. The bank was already foreign owned, it was Hong-Kong based, and it already had strong ties to China. The bank is only about $700 million in asset size and most of the bank’s business is with Chinese businesses.

However, the crucial thing will be that the Chinese will own a bank in the United States. How big it is at first and how much business it does with Americans at first is not the important thing. I go back to the advice given me some years ago: the Chinese think in terms of decades while people in the United States think in terms of years. The Chinese will own a bank in the United States!

Thus, the ground continues to change. The American banking system is going to become more and more global with the presence of foreign banks taking on a bigger and bigger role within the country. And China, and Russia, and Brazil, and India, and Canada, and others will be included. As I have stated before, I believe that the branches of foreign banks and the largest twenty five domestically chartered banks in the United States will hold more than 80% of the banking assets in the United States. There is just going to less and less need and less and less room for smaller domestically chartered banks to exist.

It is just not realistic to believe that the banking system of the next five years is going to look anything like the banking system that existed before the recent financial collapse. The owners of banks will also be different and will include governments and private-equity firms and individuals and others. We are only kidding ourselves if we think that we are going to return to anything like that. Cries of support for Main Street are just the wishful thinking of those that would like to return to the past. The world moves on.

Rather than trying to retain the past we need to ask what will be needed in the future. Parts of the American landscape are fading. One part of that landscape is the small, locally owned bank that serves just the community it resides in. My grandfather ran a small bank in a small town in the Midwest. He hated the large banks in the nearby big city and wanted to keep them out of his territory. He argued that large banks just “sucked deposits” out of a local community and only made loans to large businesses within the big city. As a consequence, the local community suffered. The small, vibrant, self-sufficient and morally-driven local community has always been a part of the American dream.

This, for better or worse, is not the future. In fact, to some, it was not the past, but that’s
another story.

The Great Recession has changed things. Let’s prepare for the future, not hope for the past.

Friday, January 28, 2011

The U. S. Budget Deficit: It's Time to Get Serious!

The United States budget deficit will reach $1.48 billion in the 2011 fiscal year, according to the Congressional Budget Office.

The response: everyone seems to be pointing fingers at everyone else.

The President, on Wednesday evening in his State of the Union address, indicated that something needed to be done about the budget deficit.

Yesterday the CBO released its figures.

The evening news reported that the White House had some general things to say about the projection but would not come out with more specifics because they were waiting for the Republican response that they knew was coming.

There’s leadership for you.

No one in the top leadership positions in the country seem to be staking out a firm position on this. Like Health Care 1, the President is asking Congress to do something, but is not willing to step down from his intellectual tower to set out a path. As a consequence, like HC1, no one in the country really knows where he stands on containing and controlling the deficit.

As a consequence, no one really seems to be serious about the deficit.

The current estimate was constructed assuming that all current law will be used as the basis for the projection. If, for example, all the Bush tax cuts are allowed to expire, as is now the law, this will result in the budget deficit climbing to about 76% of GDP in 2020.

However, if Congress does not allow these tax cuts to expire and if Medicare programs are held constant, along with other spending and taxing programs, the budget deficit will rise to about 97% of GDP in 2020. This would place the cumulative total of deficits at around $12 trillion over the next ten years.

For the last 12-18 months, I have been arguing that the cumulative budget deficit for the next ten years will come in at least around $15 trillion, given the current attitudes about the budget deficit in Washington, D. C.. In my mind, Congress, given current attitudes, will not rescind the programs that are now in place, and, like always, will add more that will only cause the cumulative deficit to rise from current projections.

It seems as if the Congressional Budget Office is coming toward my forecast as time goes forward.

And the Gross Federal Debt continues to climb: the year-over-year rate of increase is now close to 20%. The compound rate of increase in the Gross Federal Debt between 1960 and 2007 was in slightly above 7% which some of us felt was excessive.

Since it took until fiscal year 2009 for the debt of the United States to approach $12 trillion, the idea that this figure would be doubled in the next ten years seems “unreal”. Yet, that is the way things look.

And, there are three major “holders” of this debt…Japan, China, and the Federal Reserve. Going forward it seems almost surreal the proportion of the new debt the Federal Reserve may have to acquire. There is, of course, the $900 billion that the Fed is intending to acquire as a part of QE2. But, what will the Fed have to do after that? With so much government debt coming on board it is frightening to speculate.

Why am I so pessimistic? Well, we really don’t know how much the health care program is going to cost us. We don’t know what military challenges we are going to be facing. The world is very unsettled now and I don’t see how commitments are really going to be lessened over the next ten years given all the turmoil taking place around the globe. We don’t know how the budget crisis affecting state and local governments is going to work out. Many are saying that the federal government will not play any role in state or municipal bailouts, yet, can you imagine the federal government not playing a role? And, what about the housing market and the government agencies called Fannie Mae and Freddie Mac? How much is this area going to impact the federal budget? One last unknown here is the cost of getting the commercial banking system back to full solvency. No one knows what these costs might be.

The problem with debt is that the more you have the fewer choices you have. Debt reduces your room to maneuver. And, as with Europe, it seems to me that the options are running out.

The other thing about creating more and more debt is that the options become less and less desirable.

That is why you don’t want to get yourselves “head-over-heels” in debt…you want to be able to make your own choices and you want the alternatives available to you to be desirable ones.

Right now, the choices are not good! And, we don’t seem to have any real leaders around in positions of authority that will step up to the table to take charge.

Funny, but the two Presidents that did take a leadership role in budget containment were George H. W. Bush (Bush 41) and Bill Clinton. Bush 41 made some decisions with respect to taxes that arguably cost him a second presidential term. But, Bush’s efforts set the stage for the Clinton era of strong economic growth and shrinking federal deficits.

There just is no leadership on this issue coming from the places that should be exercising leadership. To be more specific, in my experience, the top person, the CEO, the person where “the buck stops”, must take a leading role in getting something done or it just does not “get done” right. Secretary of the Treasury Robert Rubin was a major force behind the Clinton move on the budget, but the effort would have gone nowhere without Clinton getting on board and taking the lead.

As with the health care bill, people are not seeing Obama carrying the flag. Oh, he talks and talks, but where does he really stand? Tim Geithner has all but disappeared. The only real spokesperson for the administration on economics and finance seems to be Ben Bernanke and his “talk” has been getting lost in all the attention being given to other members of the Board of Governors of the Federal Reserve System.

The deficit problem is not going to be brought under control immediately. But, the lesson we can learn from the situation going on over in Europe is that someone eventually must take the lead. If no leader steps out in front of the crowd, the misery just drags on and drags on. The debtors just keep banging on the door. And, what happens during periods like this? Well, you lose focus.
I have seen this doing business “turnarounds”. When things start going downhill in a business and the debtors, or regulators, keep banging on the door, you stop doing what you should be doing in order to run a good business. You just have to “put out fires.” Thus, your organization continues to go downhill.

Likewise with a government: if the focus of the government is diverted from doing what it should be doing in order to resolve budget and debt issues, the government continues to experience problems in areas it should be focusing on.

It is past time to “get serious” on the federal government’s deficit problem. Are there any leaders in the room?

Thursday, January 27, 2011

For the Banks, Mark-to-Market Accounting Dies Again!

“Strategic vision of financial executives on how to generate economic performance while controlling risk is likely to become a differentiating factor, a determinant of not only success but of the very economic viability of financial institutions in the changed world. Have leading financial firms and institutional investors come to the same conclusion?”

This is from the book “Financial Darwinism” by Leo Tilman.(

The banking industry has provided an answer and the answer is “No!”

The banks have beaten down the accounting industry: “Banks Force Retreat on Fair-Value Plan” is the title in the print edition of the January 26, 2011 Wall Street Journal; “Retreat on ‘Marking to Market’” is the title in the electronic edition. (

“Accounting rule makers, bowing to an intense lobbying campaign, took a key step Tuesday to reverse a controversial proposal that would have required banks to use market prices rather than cost in order to value the loans they hold on their balance sheets.

The debate over the proposal is the latest chapter in a battle pitting investors who wanted better disclosure of the value of bank’s assets against the banks themselves. Banks have argued against so-called fair-value accounting, saying market prices would have left them at the mercy of volatile markets and could have caused additional strain during the financial crisis.”

The banking industry is still back in the middle ages. And, this is just what Tilman is arguing about.

To Tilman, the “golden age” of banking was when commercial banks worked with a “Static Model” of banking. Banks lived off the “carry trade”: because of highly restricted and regulated banking markets, banks operated in quasi-monopoly positions where they could earn relatively high returns on the loans they made and pay zero or close to zero on the deposits they attracted, providing them with a “lusty” net interest margin (NIM). Their model was static because they could originate loans or buy securities and hold them until they matured. Marking to market was not an issue. Credit risk was the only real risk bank lenders had to be worried about.

Today a “Dynamic Model” of banking exists and the transition to this dynamic model was horrendous. The “buy and hold” strategy could no longer work. In the late 1960s, interest rates began to rise. In the 1970s, declining NIMs became a major problem and the banks countered the declining margins by moving into fee income. In the 1980s all hell broke loose as NIMs practically vanished and banks began diversifying into other assets in order to generate returns that justified their existence.

Banks did not adjust their thinking in terms of risk management during this time period. As Tilman describes in his book, as commercial banks moved into Principal Investments (α-type investments) and investments exhibiting Systematic Risks (β-type investments) their risk management knowledge and skills lagged far behind the dynamic changes that were taking place in financial markets.

On top of this commercial banks continued to add leverage to their balance sheets as a means of generating another 5 or 10 basis points or more to their return on equity.

When the cookie began to crumble, it became obvious that financial institutions had mis-managed their risk exposure and had leveraged-up to such a degree that there was little or no way to keep the cookie together. The industry had to be bailed out.

In the modern world where the “Dynamic Model” of financial management rules, the “buy-and-hold” philosophy that applied to the “Static Model” of banking is legacy.

By getting rid of “Mark-to-Market” the banking industry is kidding itself and just setting itself
up for future trauma. It is hiding its head in the sand and pretending that the world has not changed.

The world has changed. Net interest margins are not what they once were. Buy-and-hold policies are not realistic. And financial leverage is going to be more severely regulated. So who is going to manage risk if it is hidden on the balance sheet?

My advice to bank managements: mark your portfolios to market. You don’t have to, but, for once, “get real.” If you are going to buy risky long term investments…accept the fact that they are subject to interest rate risk…and credit risk. You don’t get the return unless you assume something to justify the extra return. Who are you fooling by not marking-them-to-market? You are only kidding yourselves.

Tilman argues that generating “economic performance while controlling risk” is going to be “a differentiating factor”, a determinant of success but also of the economic viability” of a financial institution.

In the 1950s and 1960s banking was a very quiet and stable environment. The industry did not attract the “best and the brightest.” There was the joke around Philadelphia that in wealthy families that had three sons, the smartest became a doctor, the next smartest became a lawyer: the dumbest became a banker.

The thrift industry was even worse. Tilman titles his book “Financial Darwinism.” In the case of survival, most thrift managements were awful, much worse than bank managements, and, the thrift industry is dead,! Are the smaller commercial banks the next in line for extinction?

When I joined the Finance Department at the Wharton School, UPENN, (in 1972) "Finance" did not have a course on the financial management of commercial banks. (I did create that course while I was there.) The reason why no bank management course existed was that the big banks, City, Morgan, Chase, and so on, did not recruit students at Wharton. They recruited from the history department, the literature department, and so forth…well, they really recruited from the social clubs, the tennis team, and the golf team. They wanted people who could socialize with customers and get along with them at the highest social levels. They didn’t want some sharp intellect that was quantitatively orientated to work in “their shop.”

Bankers have never liked uncomfortable situations. They have been notorious for keeping bad loans on their books until they absolutely have to charge them off. They are also notorious for refusing to acknowledge that some of their assets might be “under-water”. Bankers are notorious as risk managers.

Risk management is going to be a major differentiator of bank performance in the future. We have seen how inadequate risk management can help the industry self-destruct. Anyone investing in banks…or regulating banks…should pay special attention to how a management recognizes risk; the policies and procedures it puts in place to manage risk; and the efforts it makes to disclose to people the value of the assets the bank has on its balance sheet.

The banking industry is changing. I have just written up my view of some of the changes that are coming (See Good risk management is going to be a “decider” of who survives

Wednesday, January 26, 2011

China Leads the World...In Clean-Energy Power?

These are the lead paragraphs in an article on China… the “Green” nation:

“For years, China was seen as a major obstacle to global efforts to combat climate change because of its refusal to reduce emissions under the Kyoto Protocol.

Now, for some, the concern is not that China is moving too slowly but that it is rushing ahead so fast that clean-energy companies in the West will be left in the dust.” (

This article brings to mind two pieces of advice I received several years ago that I have found to be relevant over and over again.

The first is that China thinks in terms of decades, whereas the West thinks in terms of years.

This puts the West at a substantial disadvantage. We deride the Chinese because they are not moving as fast as we, who focus on what is happening “right now”, think they should be moving.

Then, when the actions of the Chinese fall into place, people in the West respond as if the success of China took them by surprise.

While the leaders in the West have focused on “legacy” issues like putting people back to work in the old jobs they got laid off from or in supporting declining industries, issues like science education (, all types of education (, and innovation take a back seat because they only have a “longer term” payback.

The second piece of advice has to do with how programs, governmental programs, should be designed. The emphasis of governmental programs should be on policies and not outcomes.

The article mentioned above contains a quote by Vincent Mages, a director for climate change initiatives at Lafarge, the giant cement company based in France, “China talks about programs and policies rather than focusing on targets.” Mages adds, “We focus on targets too much.”

When you focus too much on outcomes, desperation sets in when the outcomes are not being met. And, outcomes are generally tied to short-term time horizons. Some outcomes emphasized by the United States government have been on a 4.0% or a 6.0% unemployment rate or a housing starts goal or the real growth rate of the economy. And, these goals are usually connected with the year after they are set. Frustration in meeting these goals often lead to even more efforts to achieve them which often results in distortions of resource allocation and, even more important, they serve as a distraction from working on longer term objectives.

People in the United States do respond to needs and do respond to opportunities. Did the capital shortage expected in the 1980s ever arise? Were there any disruptions arising from Y-2000? Has America not led the world in innovation in the area of information technology? And so on.
People respond to incentives. Just check out the research presented in the two books “Freakonomics” and “Super Feakonomics.” People will cheat if the incentives are aligned in certain ways…even teachers. They will act in destructive ways if information is not open and available. They will focus on short-term outcomes if that is where the incentives are. People respond to the incentives that are embedded in the culture of a nation.

If we are not comfortable with the results we are getting, maybe we need to look at the incentives we are setting up for our children and grand-children. Maybe we, as members of this society, are, ourselves, emphasizing outcomes for people rather than programs or lifestyles.

So, maybe, just maybe, we should begin to think in terms of decades and not just in terms of the short-term results connected with next year’s or next quarter’s profits. Maybe we should take into consideration all the costs of the decisions we make and not just the immediate ones that affect us. Maybe we should become more interested in the kind of culture we are supporting and create more positively directed programs and policies and de-emphasize our efforts to achieve specific outcomes.

There are initiatives that are popping up. “Impact” investors, like those connected with Investors Circle in the United States, are growing in importance. Investors’ Circle aims to “catalyze the flow of capital to early stage companies that address major social and environmental problems as well as grow and support the network of values driven capital investors.” Return is important, but real return is based on “smart” decision making not just expedient decision making.

There is also a new breed of commercial banks being formed like New Resource Bank in California, Green Choice Bank in Chicago, and e3bank in near Philadelphia Pennsylvania. (Note of disclosure: I am on the board of e3bank and an investor in that organization.) These banks emphasize “smart” decision making with respect to clean-energy and the inclusion of the longer term costs of not taking into consideration environmental impacts. These efforts focus on decisions that have consequences over decades and not just on next year’s profits.

These efforts, however, are just small ones. They have not achieved the scale that the Chinese effort has achieved. And, until greater “scale” is achieved, “the West will be left in the dust.”

Maybe, just maybe, this competition from China is just what we need. We, in the West…and in the United States…have been very smug about our leadership in the world. Here is a “space” in which this leadership may cease to exist in the very near future.

Could this be the “jump start” we need to get the ball rolling? Nothing drives us harder than competition. We’ll see.

Friday, January 21, 2011

Banking is Changing: Look Out for the Opportunities

Banking is changing. I have argued this case for a long time. The number of banks in the banking industry is declining. A year ago or so we had over 8,000 commercial banks in the banking industry and several thousand organizations called thrift institutions. Now, we have less than 7,800 in the banking system and the thrift industry is legacy. My guess is that over the next five years, the number of commercial banks will drop below 4,000. This, of course, does not consider the credit unions and the increasing role they play in financial services.

The largest 25 commercial banks in the banking system hold about two-thirds of the assets of domestically chartered banks in the banking system. These banks hold over 57% of all the banking assets in the United States. Foreign-related financial institutions hold almost 13% of all banking assets in the United States. Thus, the biggest 25 domestically chartered banks in the United States banking system plus foreign-related financial institutions in the United States hold 70% of all banking assets.

This means that the average size of commercial banks not included in the largest 25 banks is a little more than $450 million. This means that there are a lot of very, very small banks “out there.”

What if the 25 largest banks in the United States plus foreign-related financial institutions move up to 80% of the total banking assets in the United States which I believe will happen? If the banking system drops to below 4,000 banks and, just to build an estimate, the asset size of the banking system doesn’t grow, then the smaller banks in the banking system will average right around $600 million.

The only conclusion that one can draw from the assumptions I am working with is that the big banks are going to get bigger, foreign banks are going to play a larger role in the United States banking industry (See “Japan’ No. 1 Bank on Prowl,”, and the smaller banks are going to get bigger.
Given this scenario the question becomes “How are commercial banks going to change?”

I would like to call your attention to a book I reviewed back in August by Leo Tilman, “Financial Darwinism,” ( The book is subtitled “Create Value or Self-Destruct in a World of Risk.”

One distinction Tilman makes in his book is between the “static” model of financial management and the “dynamic” model that incorporates a totally different risk-management perspective.

The general “mode of operation” of institutions existing within a “static” framework is akin to the “carry trade.” Simply, the “carry trade” can be defined living off the differential returns between assets and liabilities. Because of the “local monopolies” that commercial banks historically operated in that were controlled and regulated by the banking authorities, commercial banks could engage in “balance sheet arbitrage” and earn a very good living. (Lend at 6%, borrow at 2%, and be on the golf course by 4:00.)

As the local monopolies broke up in the 1970s and 1980s and the Net Interest Margins of banks began to decline, commercial banks started concentrating on fee income to keep returns up. But, this only worked for so long. As a consequence, Tilman argues, financial institutions, particularly the larger ones, began moving into “Principal Investments” and “Systematic Risks.”

Principal Investments (primarily “alpha” type of investments) include private equity funds and venture capital investments, proprietary trading, hedge fund activity and other forms of investment in financial instruments, products, and tools. Decisions were generally made at executive levels, but were decentralized with risk only being considered within a specific silo.

Examples of Systematic Risks (“Beta” type of investments) include operating in markets where the organization were exposed to interest rate risk, credit risk, mortgage prepayment risk, commodity risk, currency risk and so forth. Again, these efforts tended to be compartmentalized.

Even for the bigger institutions these latter movements were not aggregated and integrated: risk management in these financial institutions remained “static” even though the world became “dynamic.”

For the smaller commercial banks that moved in this latter direction, they tended not to know what they were doing. In doing bank turnarounds, it always amazed me the number of managements that felt they could deal with the most sophisticated financial instruments available, yet couldn’t manage their own “balance sheet arbitrage.” Moving into areas that were not based on “traditional” banking models only exposed these smaller banks to disaster as markets collapsed and they descended into insolvency.

The bigger banks have learned a very costly lesson relative to risk management. This is what Tilman’s book is all about. Within the dynamic world of modern finance, commercial banks are not going to be able to live off of “balance sheet arbitrage” alone. More and more these bigger banks are going to build portfolios of “Principal Investments” and investments with “Systematic Risks.” But, they are going to integrate and manage their risks differently. And, the management of these risks are going to be world-wide as the United States banks take on more of a global presence and as foreign-related financial institutions become more prominent in the United States. (

One major differentiator of performance in large banks is going to be tied to the ability of top management to manage the risk of their multi-structured institutions. This is one of the reasons why Jamie Dimon and JPMorgan, Chase & Company supposedly got through the recent financial collapse as well as they did. (

Smaller banks, however, are not going to be able to operate in these areas requiring a sophisticated understanding of how these risks are managed but also require a very sophistication management team to manage them. The smaller banks are going to have to find out how they can become better at “balance sheet arbitrage” and build up an expertise in these areas so as to “out-execute” rivals. This will be their way to “raise the bar.”

The other major differentiator will be the control of expenses: this will have to do with the structure of the branching system and number of bank personnel. It is embarrassing to walk into sizeable bank branches these days and see five employees of the bank and maybe two or three customers. I don’t remember walking into a bank recently where this was not the case.
Furthermore, commercial banks are way over-staffed in their back offices. Managements have not really dealt with this issue in recent years because they have either been “dancing to the music” or had major solvency proglems to deal with. But, now attention is starting to be paid to the excessively high expense ratios that exist within banking. (

One way the banks are going to change in this area is in their use of information technology. ( I plan to spend more time on this in the future and will also be spending more time discussing banks that are changing.

Thursday, January 20, 2011

U. S. Financial Rules and Regulations are Making U. S. Financial Institutions and Markets Irrelevant

I can’t recommend highly enough the opinion piece in the Wall Street Journal this morning “The SEC’s Facebook Fiasco,” by Jonathan Macey. ( I have written something myself on the issue: see “The Pace of Financial Overhaul.” (

Macey sticks with the problems of the SEC and the regulatory structure and philosophy that surrounds it. But, the points he makes are also directly applicable to the regulatory structure and philosophy that surroundsl the laws and regulations impacting financial services and financial markets.

Let me restate some of the points that Macey makes and then add a couple of my own.

1. Banking has become so international that companies can side-step rules and regulations with ease.

2. Many of the rules and regulations that exist are crippling for United States financial transactions.

3. Banks have been moving brokerage and banking business offshore for decades. They are well positioned in Asian and European capitals to continue to do so.

4. The whole capital formation process is moving offshore.

5. The number of United States companies listing their shares for trading and doing business exclusively in foreign markets has risen steadily for the past five years.

6. Banks have to conduct the business they currently do in the United States so that they can avoid more egregious and intrusive regulations in the future.

7. In an effort to protect the unsophisticated small investor, rules and regulations are driving banks to provide “good deals” to wealthier clients avoiding where ever they can the less wealthy.

This is a pretty good list, but let me just add three more to it.

8. The rules, regulations, and economic policies of the United States over the last fifty years has created an environment that benefits the larger institutions and has made it more and more difficult for smaller financial institutions to survive. The larger institutions are the ones that are more capable of acting in the way described in the previous seven points listed above.

9. More and more assets in the United States are held by foreign banks than ever before and foreign banks are actually being encouraged to acquire banks within the United States, especially troubled banks. These foreign banks already have an international presence.

10. The application of more and more information technology to the financial services industry is just going to accelerate all the movements listed in the above nine points.

Macey closes his opinion piece by stating that the review of regulations proposed by President Obama should include the rules “promulgated by the SEC, lest we continue to see U. S. capital markets fade into irrelevance.” I believe that Mr. Macey’s statement can be broadened to include the rules and regulations applying to financial institutions and financial markets in general.

Wednesday, January 19, 2011

The Pace of Financial Overhaul

The writing of new financial regulations required by the Dodd-Frank financial reform act passed last summer seems to be dragging. “Regulators have missed or postponed several deadlines to write rules needed to implement the financial overhaul…” (

The writing of such regulations in the world of modern finance is a very difficult and messy task at best and one that is even harder given the speed at which that world is changing. In some cases, definitions need to be revised such as who is an “accredited investor”; hearings are taking longer than expected; and disagreements need to be worked out. Furthermore, the regulation-writers are being careful because they “want to get it right.”

“In the next 18 months, U. S. regulators are supposed to issue more than 100 rules or studies in response to the Dodd-Frank law.” And, “The political deadlock in Congress over spending has left the SEC and CFTC without budget increases needed for the task.”

All this means to me, however, is that Congress and the regulators are just falling further and further behind which just makes what they are doing more and more irrelevant!

I have written many posts over the last two years or so about financial regulation and regulatory reform. Most of them have not been very encouraging concerning the positive benefits of the effort now going on to re-regulate the United States (and the world) banking system. The most comprehensive comment that I have made is that the re-regulation that is going on is already “out-of-date.” The reasons I give for this comment is that politicians and regulators are always fighting the last war and so start out behind and the bankers have already moved on into the future making the things being done even further “out-of-date.”

But, just notice three more bits of news that have been in the news in recent days, weeks, or months. First there is the phenomenon known as WikiLeaks. Not only has WikiLeaks “outed” the United States diplomatic system and threatened to disclose internal information said to be very embarrassing to certain United States banks, there is now the threat to expose 2,000 prominent individuals and companies that have been engaged in tax evasion and other possible criminal activity. This latter information was supposedly contained in two computer disks given on Monday to the founder of WikiLeaks by a former senior Swiss bank executive.

This “leaking” of information gets at one of the basic problems connected with information and information storage: security. The issue has to do with who has what information and who should be excluded from having certain information.

One of the fundamental ideas related to information theory is that “information spreads”. People try to control information and contain its spread, but this only slows down the speed at which information spreads…it doesn’t stop the spread.

Just ask the governments and religions that have tried to control information and thinking.

Just think of all the hackers out there. I very firmly believe in the “efficient markets” theory of hacking. That is, if someone can benefit in some way from hacking into a system, even to just embarass someone, they will find a way to successfully hack into that system.

Some information governments would not like others to have, like secrets related to national security. It was proven in the 1990s that all current “code” systems used to protect secrets are useless if someone has a Quantum Computer. Thus, a government like the United States believes that it needs to be “first” in creating a Quantum Computer so that it can keep these very important secrets. (

My point is that in the world of information technology in the 21st century where information, even secret information, is so accessible, shouldn’t the government and the regulators show a little more interest in the openness and transparency of the financial institutions and the financial markets than it is showing.

The politicians and the regulators are looking for very specific outcomes. History shows that governments that try to force “outcomes” on a system NEVER SUCCEED!

It is remarkable how systems and markets are more able to regulate themselves if information is open and transparent to all. Maybe this is what Congress and the regulators should be emphasizing.

Second, there is the Goldman Sachs/Facebook transaction. Rather than have a public offering of shares in Facebook, Inc., where a substantial amount of information on the company would have to be forthcoming, Goldman decided that a private offering was better for the company at this time. Now, with concern that the focus on the private offering could be deemed “public” because of the intense attention given to the deal in the media could be considered a violation of U. S. securities laws, Goldman has decided to only offer the shares to non-United States investors.

My point here is that something is wrong with the regulations for such a “mess” to exist. First of all, what is “private” information and what is “public” information? Secondly, if others, like the media, can get sufficient information and publish it so that a “private” offering becomes a “public” offering even if the bank conducting the offering does not actively violate the law, what really is the definition of a “private offering”?

Third, in this global world, an offering such as the Facebook shares, can be taken “off-shore” as easily as sending an email out to potential investors. Should our laws and regulations be set up so as to “force” companies to go elsewhere in the world and escape onerous” regs” or “out-of-date” restrictions?

Fourth, in the information technology world we are moving into how can any financial offering be considered “private.” The possibilities that the “private” offering might become “public” are almost infinite.

Just one final tidbit: the Wall Street Journal article “Battle for Techies: Wall Street vs. Silicon Valley.” ( The subtitle to this article is “Trading Companies Roll Out the Perks to Lure Top Talent; Shuffleboard, Paintball and, Yes, Higher pay; Outside the Bubble.” Wall Street believes it needs the best “techies” to compete in the modern world.

The point: information technology is very present in finance, after all, finance is just about information. Information technology is playing a bigger and bigger role in finance. See my book review of “The Quants”: ( And, information technology is going to play an even bigger role in finance in the future.

Obviously, my belief is that the current efforts to write new rules and regulations for the financial area are on the wrong track and wasting a lot of money. But, these efforts are creating jobs and that is helping the economy. Maybe the financial reform bill was really just a stimulus bill in disguise

Tuesday, January 18, 2011

Where is the Inflation? All Around!

Ronald McKinnon writes in the Wall Street Journal this morning, “The U. S. is a sovereign country that has the right to follow its own monetary policy. By an accident of history, however, since 1945, it is also the center of the world dollar standard...So the choice of monetary policy by the Federal Reserve can strongly affect its neighbors for better or worse.” (

Charles Plosser, President of the Federal Reserve Bank of Philadelphia, stated in Santiago, Chile yesterday: ”I believe we have come to expect too much from monetary policy.”

In terms of what monetary policy can do, we know that one of the fundamental lessons of economics is that “Inflation is, everywhere, at every time, a monetary phenomenon.”

Monetary policy cannot produce full employment, or retract over-investment, or fund state and municipal government pension funds that have been under-funded for years. Monetary policy cannot educate or train people for today’s jobs.

Monetary policy cannot make commercial banks solvent that have made bad loans or investments.

McKinnon asks, “What do the years 1971, 2003, and 2010 have in common? In each year, low U. S. Interest rates and the expectation of dollar depreciation led to massive ‘hot money’ outflows from the U. S. and world-wide inflation. And, in all three cases, foreign central banks intervened heavily to buy dollars to prevent their currencies from appreciating.”

But, the U. S. is a sovereign country that has the right to follow its own monetary policy...

And, how is this happening?

First, money flows into auction markets such as commodity markets or foreign exchange markets. (

Second, funds begin to flow into other areas of non-United States economies. Consumer price indexes have been rising in many of the emerging countries around the world. In particular, China, Brazil, India, and Indonesia have experience increases in their price indexes of more than 5% in 2010. In both the Eurozone and in England, the central banks are having to deal with the problem that, despite slow economic recovery and reductions in government spending due to the sovereign debt crisis, recorded inflation is exceeding their long run inflation targets.

Only after some lag time takes place does the inflationary pressures get built up within the United States. This lag time may be as much as five years, especially given the structural problems that exist in the United States economy. ( This is the historical experience.

Notice, that in two out of the three dates that McKinnon highlights, Ben Bernanke played a prominent role. Bernanke was a board member of the Federal Reserve during the 2003 time period and helped to compose the justification for the Fed’s policy at that time. Of course, Bernanke is currently the Chairman of the Board of Governors.

One must also remember that it was Chairman Bernanke who continued to fight inflationary pressures into the late summer of 2007 before the Fed totally had to reverse their policy stance when Bear Stearns declared bankruptcy. (

Mr. Bernanke does not have a very good record in judging when he, and the Fed, are heading in the wrong direction. Zero for three is not a very good batting average!

The consequences of inappropriate economic policy work themselves out slowly, but they also inevitably work themselves out. This is the message in the research of Ken Rogoff and Carmine Reinhart. (

Here we need to quote another fundamental lesson of economics: monetary policy works with long and variable lags.

Monetary policy takes a long time to work itself out throughout the economy. And, the effects of monetary policy cannot be reversed quickly.

One of the reasons why some economists have argued that monetary policy should be conducted according to “rules” rather than “authority” is that, historically, the track-record of policy makers is not so “hot.” And leaders that have a batting-record of zero for three do not add anything to the confidence level.

Where is the inflation?

It can be found throughout the world. The United States is “the center of the world dollar standard.” What the United States does in terms of monetary policy affects the world! And, what is happening in the world, sooner or later, also affects the United States. McKinnon is arguing that this is the historical record.

Monday, January 17, 2011

The Two Banking Systems in the United States

More and more it appears as if the banking system of the United States is bifurcating into two parts, the largest 25 banks and the rest. These designations, large and small, are used by the Federal Reserve System for the data they release for the whole commercial banking system.

Over the past year, the total assets of the domestically chartered commercial banking system in the United States hardly grew at all. Yet, throughout the year, the smaller banks made their balance sheets much more conservative than did the largest banks.

For one, the smaller commercial banks increased their holdings of cash assets by 10% from December 2009 to December 2010; the largest banks decreased their cash holdings by more than 21%.

Both the large banks and the smaller banks increased their securities portfolios over the year, but the smaller ones increased their securities portfolios by almost 9% while the largest banks increased theirs by only about 3%.

Over the whole year, Commercial and Industrial Loans declined across the board with the larger banks portfolio of C&I loans dropping by almost 5% while in the smaller banks, C&I loans fell by only about 3%. Real Estate loans also fell during the year dropping about 4% and 5% at the largest and the smaller institutions, respectively. Consumer loans were re-defined over the year for this Federal Reserve release so that the data year-over-year growth rates are not meaningful.

The largest declines since December 2009 came in commercial real estate loans. At the largest banks, commercial real estate loans dropped by almost 11%; at the smaller banks they fell by 8%. The troubles in the commercial real estate area show up very clearly in the banking statistics.

The conservative movement in the balance sheets of the smaller banks was continued over the last 13 weeks ending with the banking week finishing on January 5, 2011. Total banks assets fell during this time period, but not by very much. Over this time period, however, the smaller banks increased their holdings of securities by over 7% while their loan portfolios fell by more than 3%.

During this time period, loans making up the loan portfolios of the smaller banks fell across the board: C&I loans dropped by 4%; real estate loans fell by 3%; and consumer loans declined by about 4%.

The loans at the smaller banks also continued to drop through the Christmas season with C&I loans falling by over 2% in the five-week period ending January 5, 2011; real estate loans fell by just 2% during this time period; and consumer loans dropped by almost 5%.

Interestingly enough, there was a front page article in the Saturday Wall Street Journal with the title “Banks Loosen Purse Strings” which reported data from Equifax Inc. and Moody’s Analytics. ( In this article the claim is made that “In the third quarter (of 2010), lenders made more than 36 million consumer loans, up 3.7% from a year earlier...That is the first year-over-year gain since the crisis began. Consumer-loan originations are expected to climb 5.9% this year, much higher than the slim 1.1% increase in 2010.” The article goes on to say that “The totals include bank-issued and retail credit cards, auto loans, consumer-finance loans, home-equity lending and student loans”. Whoops, these are not all banks are they!

But, the commercial banks do not seem to be opening their purse strings when it comes to consumer lending. Besides the drop of 5% in consumer loans at the smaller commercial banks, the Federal Reserve data also showed that consumer loans fell by 5% at the largest 25 commercial banks over the past 5 weeks.

Again, the largest declining loan class over the last 5 weeks was still the commercial real estate loan area. The decline at the largest banks in the last 5 weeks was a little under 1%, while the decline at the smaller banks in this area was over 2%.

Everywhere, the aggregate banking statistics can be interpreted as showing that the smaller commercial banks continue to “tighten up” their balance sheets. The loan portfolios of these banks experienced further declines while the banks keep building up their cash positions and the size of their securities portfolios. The largest contractions have come in commercial real estate, the area that seems to have the biggest cloud over it for the next year or two.

Generally, the largest 25 domestically chartered banks in the United States seem to be doing well.

Of course, we all heard about the 47% profit jump at J.P.Morgan Chase which was announced on Friday. This week we will get more information on how the other “large” commercial banks are doing. It is expected that the reports coming out this week will show that the bigger banks are pulling ahead.

Of interest is the areas of lending that seem to be picking up at these larger banks. For one, commercial and industrial loans are, indeed, starting to increase. Over the past 13-week period, the largest 25 banks saw their portfolios of C&I loans increase by more than 3%; these loans also showed a gain over the past 5-week period.

The one other lending area that seems to be picking up at these larger banks is the area of residential loans, mortgages. (Note: this does not include equity-line loans.) Over the last 13-week period, residential real estate loans have picked up by slightly more than 3%; these loans also registered a modest increase over the last 5-week period.

So, I still firmly believe what I wrote in my January 3, 2011 post, “Four ‘Uncomfortable Situations’ to Watch in Early 2011,” ( Two of these four “uncomfortable situations” are the health of the commercial real estate area and the solvency of commercial banks that fall into the small- and medium-size category.

The small- and medium-sized banks continue to “pull-in-the-carpet.” That is, these banks continue to shrink their balance sheets and they continue to re-allocate assets to either cash or “safe” Treasury securities. They have been doing this for more than two years and show no signs of acting any differently in the near future. To me, this behavior is a real “red flag” that these institutions are not doing well.

And, these smaller banks seem to be getting commercial real estate loans off their balance sheets as fast as they can just re-confirming the problems that exist in this area.

The Federal Reserve continues to pursue the policy they call “Quantitative Easing.” Perhaps a better name for it would be “Keeping the Smaller Banks Liquid.” The reason, I have argued, for keeping the smaller banks liquid is that this allows many of these smaller banks to keep their doors open in the short run so that the Federal Deposit Insurance Corporation (FDIC) can close as many of these banks as they need to in as orderly a fashion as possible. The data continue to support this conclusion.

Friday, January 14, 2011

The Bubbles Are Real

On Thursday, three-month forward contracts put the yield spread between Brazilian and United States rates at 8.75 percentage points. And, you have questions about the existence of the carry trade, the borrowing at excessively low interest rates in one country to invest at much higher rates in another country.

Well, these yield spreads are not quite as attractive as they once were because Brazil has placed a tax on foreign investment in sovereign bonds. This tax was initiated in 2009 and after two increases is now 6 percent. Several fund managers told the Financial Times outlet that “the appeal of the carry trade had diminished considerably as a result.” (

Two points on this: first, there is no doubt in my mind that the quantitative easing (QE2) on the part of the Federal Reserve System has created bubbles in other parts of the world: and second, countries around the world have reacted to these bubbles by selectively trying various policy tools to try and contain the capital flows into their financial markets confirming, to me, that the bubbles are real.

Yesterday, the Brazilian central bank introduced a new effort to slow down the rise in the Real “by offering to buy as much as $1 billion in the currency futures market. (“Brazil Central Bank Intervenes,”

But, governments all over the world are trying to clamp down on “hot money flows”. Gillian Tett writes about “New Ways to Control Hot Money Bubbles,” in the Financial Times this morning. (

South Korea, in particular, is “launching” experiments aimed at stemming rising currency prices or frothy stock markets or other cross-border flows of funds. The effort is to find ways to apply more activist and “macro-prudential” policies to banks or the banking system.

Even the International Monetary Fund, this week, recognized the legitimacy of and the need for

countries to control capital flows when other countries are following independent economic policies aimed at resolving domestic economic problems that have impacts on others.

The problem is “what constitutes a bubble?”

A bubble seems to be like pornography, it depends upon who is looking at it. Former Federal Reserve Board Chairman Alan Greenspan never saw a bubble, at least while it was taking place. Apparently, the current chairman Ben Bernanke can’t see one either.

Now, it seems, that there are other economic phenomenon that are maybe not so easy to identify. United States Treasury Secretary Tim Geithner has stated that it is hard to identify financial institutions that are “systemically important” in advance of a crisis. “It depends too much on the state of the world at the time. You won’t be able to make a judgment about what’s systemic and what’s not until you know the nature of the shock.” Well, so much for “too big to fail.” (

Still, there are flows of funds that seem very “bubble-like” Take a look at the following chart. Notice the flows of funds into emerging markets in 2009 and 2010. It was December 2008 that the Federal Reserve forced the effective Federal Funds rate into the range of 15 basis points to 25 basis points. Fund flows into emerging markets took off to new highs once this policy was in place. Who says the international flow of funds is restricted.

The next point, however, is the movement in the exchange rates in these emerging countries relative to the dollar. Note, the figures presented are the percent change over the past two years.

One definition of a bubble is when fund flows into a nation or a sector exceed the ability of real economic activity in that nation or sector to grow. In the case of funds flowing into these emerging nations it certainly appears as if the funds flowing into the countries exceed the ability these countries have to grow.

Raghuram Rajan and Luigi Zingales, in their book “Saving Capitalism from the Capitalists” argue that bubbles occur when you get people investing in markets that are not familiar with the markets, people who don’t really understand the fundamental characteristics of the new market they are investing in. As a consequence, people make money as prices continue to rise and this fact draws more and more people into the market place. In this respect, bubbles can possibly be observed by paying attention to who is being drawn into the market. This can be another piece of evidence in attempting to discern “bubbles.”

Thus, the carry trade has proven to be very attractive, has produced a lot of profitable positions, and has gained a lot of publicity in the popular press and in the investment community. One could argue that investments in the bonds and equities in emerging nations have drawn a lot of new investors over the past two years. More are coming into the markets every day.

One can also make a similar case for the flurry of activity in world commodity markets.

In fact, one could argue that in many of these situations policy makers are setting up attractive “one-way bets” for investors and these are drawing new money into these areas from investors not familiar with the markets. (

It seems to me that in present circumstances it is harder to argue that bubbles ARE NOT real than that they really exist.

Thursday, January 13, 2011

Why Debt Is Going To Continue To Be A Problem In The United States

Officials at the Federal Reserve and in many other leadership positions around the world believe that liquidity is the solution to our current woes. And, if the amount of liquidity that is in the anking and financial markets is not enough to resolve our problems then more liquidity is certainly the answer.

This is behind QE2, and this is behind most of the effort to resolve the sovereign debt crisis in Europe.

What does liquidity allow you to do? It allows you to sell assets into the marketplace.

However, selling assets into the marketplace does not solve your problems if the price at which you sell the assets is substantially below the accounting value of the assets on your balance sheet. In such cases, having liquid markets in which to sell assets may allow you to more than wipe out your equity and leave you unable to pay off your debts.

There are two ways to counter this problem. The first is to inflate prices so that the real value of the debt declines which reduces the amount of leverage you have on your books. The second is to create income and wealth so that equity increases relative to the debt outstanding thereby reducing leverage.

The people advocating the injection of more liquidity into the financial system hope to spur bank lending and thereby stimulate economic growth. Those that are concerned with the creation of more and more liquidity argue that this first group of people really just want to create inflation and reduce the real value of the debt.

The problem I see unfolding is that the economy is expanding and will continue to expand in 2011, but it will not expand in such a way as to stimulate sufficient income growth and wealth creation so as to lower the debt loan many people are bearing. As a consequence, the further liquefying of the banking and financial markets will just benefit those who are not too highly leveraged…generally the financially better off in society…and continue to depress those who are highly leveraged.
In terms of economic growth, the economy is expanding. However, by historical standards, the year-over-year rate of growth of real Gross Domestic Product is substantially below the general recovery pattern. In the year-over-year rates of growth in 2010 were 2.4%, 3.0%, and 3.4% in the first, second and third quarters, respectively. Historically, at this stage of the recovery, the growth rates are usually much greater.

The problems come when we observe some very basic facts with respect to economic performance. First, although Industrial Production has recovered from the lows reached during the recession it has not come close to reaching the peak it attained before the recession set in. Second, the capacity utilization of our manufacturing has recovered, yet it still lies well below its previous peak (which is the lowest peak achieved since the statistical series was begun in the 1960s). Finally, even though unemployment dropped last month, under-employment continues to be extremely high as I estimate that one out of every four or one out of every five individuals of employment age are either unemployed, working part time but would like to work full time, or have dropped out of the work force. This phenomena is captured in the data on the Civilian Participation rate. Note, that this rate is substantially below the level it was before the Great Recession began in December 2007 and is also even further below the level reached before the 2001 recession. Under-employment in the United States has been growing, almost steadily, since the latter part of the 1960s.

Even though corporate profits are rising dramatically, even though many large corporations are acquiring other corporations at a very rapid pace, even though commodity prices are going through the ceiling, even though the big banks are doing very well, thank you, there seems to be a real structural problem in the United States. Liquidity is helping a lot of people but it is not the people we are talking about in this

Wednesday, January 12, 2011

The 10-year Treasury Bond Yield

On December 21, 2010, I made the following brash prediction:” my view of long term Treasury yields for 2011 is up, with the 10-year Treasury security reaching 4.5-5.0% in the upcoming year, a rise from around 3.3% to 3.5% now“ (

I still believe that this is where the yield on the 10-year Treasury security should be. The reason that it is not at this level for two reasons: first, because United States Treasury issues are still attracting a lot of money that is staying away from risk elsewhere in the world; and second, the Federal Reserve System is supplying lots and lots of liquidity to the financial markets (through QE2) in order to keep banks, state and local governments, and the housing market afloat (

As can be seen from the chart, the yield on 10-year Treasury securities dropped off at the start of the recession which began in December 2007, but then nose-dived as the investor “flight-to-quality” accelerated in 2008. After some stability was re-established in 2009 the yield rebounded into the 3.5% to 4.0% range until 2010 when the sovereign debt crisis took place in Europe.

Note that the Federal Reserve maintained the effective Federal Funds rate within the 15 to 20 basis point range from December 2008 until the present. Excess reserves in the banking system that were less than $2 billion in August 2008, rose to just under $800 billion in December 2008 and averaged around $1,000 billion from October 2009 to the present. Thus, banking and financial markets were sufficiently liquid during this time period.

Right now, the yield on the 10-year Treasury securitiy seems to be dominated by what is going on in Europe. (See the next chart.) We see that this yield was moving in the 3.6% to 4.0% range at the start of 2010. However, as the sovereign debt crisis picked up momentum in the early part of the year, money flowed from European financial markets to United States financial markets.

As the European Union and the European Central Bank seemed to be working out a “bail out” plan for the eurozone nations and banks, confidence seemed to pick up in Euorpe and money once again flowed out of the United States and back into European financial markets.
Perhaps a leading indicator of this money flow could be the value of the United States dollar relative to the Euro. Although the yield on the 10-year Treasury did not begin to decline until April 2010, the United States dollar got stronger relative to the Euro beginning in January 2010. As the European bailout became a reality in the summer, the Euro began to gain strength in June 2010. The yield on the 10-year Treasury started to pick up again in August 2010 but its rise did not really accelerate until October 2010.

Note that as the concern over the sovereign debt problems in Europe rose again toward the end of 2010, the value of the Euro started to weaken again relative to the United States dollar. The rise in the yield on the 10-year Treasury security stalled.
This week, Greece issued bonds on Monday and these securities were relatively well received. Likewise, Portugal had a good reception for its issue of bonds brought to market yesterday. Spain comes to market tomorrow. Along with these successes, the value of the Euro relative to the US dollar rose slightly.

In addition to this, the yield on the 10-year Treasury issue rose Tuesday and was up again this morning.

It appears as if the near-term movement in the yield on the 10-year Treasury issue will depend more on how international investors move their money between European financial markets and the financial market in the United States.

The impact of the Federal Reserve on this? To me, the Fed is primarily interested in the liquidity available to the financial markets and the solvency of the American banking system. It is not going to change its policy stance at the current time. But, its effect on the 10-year yield will be minimal at this time.

Thus, the 10-year Treasury yield is going to bounce around as it has for the last year based upon how successful Europe is in overcoming its debt problems. I still believe that the Treasury yield would rise to the 4.5% to 5.0% this year if the European situation were not having such an impact.

Tuesday, January 11, 2011

The World Debt Crisis Lingers

The Federal Reserve, the European Central Bank, the Bank of England, and others, are all desperate to keep interest rates from rising. The debt overhang in the developed world is humongous and any substantial rise in interest rates would just exacerbate the financial crisis that hangs over Europe and America.

We observe the debt crisis all around us. Gretchen Morgenson writes in the Sunday New York Times about the need of commercial banks to write off billions of dollars of mortgage loans sold to Fannie Mae and Freddie Mac. The article is “$2.6 Billion to Cover Bad Loans: It’s a Start,” ( She writes, “Analysts in JPMorgan Chase’s own research unit published a report last fall stating that possible mortgage repurchase liabilities for the overall banking industry ranged from a best case of $20 bill to a worst case of $90 billion.”

The Financial Times reports that “US Regional Banks Set for Consolidation,” ( The gist of this article is that commercial banks have about $1,500 billion in commercial real estate loans coming due over the next four years. People have been watching these loans for about 18 months now, but they have been kept “evergreen” as bank lenders have continually renewed these loans to keep them on the books till “something good happens.” The article list 15 regional banks that have loan portfolios consisting of, at least 38% of their loans in commercial real estate loans. Seven of these banks have more than 50% of their loans in commercial real estate. The smallest of these banks is $4.2 billion in asset size.

Many corporations in the United States and Europe still have massive debt loads that continue to increase. Several times a week there is more news about corporations facing bankruptcy. Yesterday, Sbarro announced that it was hiring bankruptcy lawyers ( Last week, the Philadelphia company Tastykake indicated that it was looking for someone to buy it because of the debt problems it was having.

Another article in the New York Times on Sunday reported on “The Crisis That Isn’t Going Away,” ('t%20going%20away&st=cse). This article was about a report produced by Willem Buiter, Chief Economist at Citigroup, who claims that debt restructuring in Greece, Ireland, and Spain is inevitable: “All bank and sovereign debt is now at risk…” European debt levels, he argues, are unsustainable.

This argument is re-enforced by the information contained in another article in the Financial Times, “Europe’s Woes Put Debt Restructuring Back on the Agenda,” (

Not only is the sovereign debt of Portugal currently under attack but Belgian bonds came under attack yesterday.

The debt estimates for 2013 are downright scary: Greece is expected to have its debt at 144% of GDP in 2013; Italy at 120%; Belgium at 106%; Ireland at 105%; Portugal at 92%; France at 90%; the UK at 86%; and Spain at 79%.

And, what about European banks? Check out the article “Fears Mount Over European Debt, Banks,” ( European banks are expected to go through a new “stress” test this year, one that will be much tougher than the “joke” that was administered last year. There is great concern about how these European banks will fare in the new test.

And what about government debt in America? New governors are taking a tough stance on the budgets for the upcoming year. Jerry Brown is seeking $12.5 billion in spending cuts for the upcoming California budget. And, Andrew Cuomo in New York is asking for salary cuts of 10% and is seeking even more cuts elsewhere. The governor of Illinois is (seriously) hoping that the lame-duck legislature will pass a substantial tax increase on corporations before they leave. Still many states are in dire straits, hoping to avoid bankruptcy. And, there are dozens of municipal governments on the edge of declaring bankruptcy.

Oh, and what about the federal government: Have you seen the projections for interest expense going forward given the deficits that are expected in the future?

Now, what if long term interest rates were to rise by another 100 basis points? 150% basis points?

Just how much longer can the central bankers of the world keep long term interest rates below where the market believe they should be?

Research indicates that central bank actions can keep long term interest rates lower than market conditions warrant for a short period of time. However, to maintain the rates at below market levels, central banks must inject increasing amounts of money.

QE2 was announced as a policy decision to get the economy growing faster so that the unemployment rate would be brought down.

Yet, now we see what a farce the Fed has been playing on us. Chairman Bernanke, himself, just told Congress that the unemployment rate was not going to improve much at all, even if the economy picks up speed, and that it would take five to six years for the unemployment rate to even show much of a decline.

So, one can conclude from this that QE2 is not really aimed at getting the unemployment rate down.

I have argued for a long time that the reason the Fed was providing the financial markets with so much liquidity was because of all the insolvent banks “out there”. The Fed was helping to keep banks “open” so that the FDIC could close all the banks that needed closing in an orderly fashion.

I believe that investors are coming to realize that the Fed is not trying to keep rates down in order to spur on the economy. To me, this realization contributed to the fact that the yield on 10-year Treasury securities rose by about 100 basis points after the Fed laid out its plans for QE2. The financial markets just rebounded to levels that more closely approximated where the market should be if the Fed were not “messing” with it.

Bottom line: the debt problem is still real. There is a lot of debt “out there” and the value of this debt is not really the economic value of the debt. The central banks of the world are just trying to keep long term interest rates low in order to push off the day when the debt will have to be written down to a more realistic value. The problem is that more and more attention is being paid to the fact that this debt needs to be written down. And, until this write-down takes place, we cannot really recover, economically.

Monday, January 10, 2011

Federal Reserve QE2 Watch: Part 2

The second application of “Quantitative Easing” on the part of the Federal Reserve System has now been on the books for several months. So, what has been going on at the Fed over this period of time?

One difficulty in examining the period running from the middle of November to the first of January is the “operating” factors that impact bank reserves due to the holiday season and end of year activity.

One such operating factor is that individuals and businesses build up their cash holdings seasonally in order to meet the needs of the holiday purchases. The Fed usually supplies this currency “on demand.”

In addition, due to pending government disbursements, the United States Treasury usually builds up its General Account at the Federal Reserve, the account the Treasury writes checks against.

In the four week period ending January 5, 2011, currency outstanding rose by almost $3 billion and the General Account of the U. S. Treasury rose by $86 billion, a total of $89 billion in reserves that the Fed had to replace in the banking system through its purchase of securities. These were all “operating factors” the Federal Reserve had to deal with.

In the thirteen weeks ended January 5, 2011, currency outstanding rose by about $22 billion and funds in the Treasury’s General Account rose by $56 billion. Furthermore, there was an accounting adjustment related to the AIG bailout operation which withdrew another $27 billion from the banking system in the third quarter of 2010 that also was replaced by the Fed’s purchase of securities, bringing the total of off-setting Fed purchases during this time period to $105 billion.

Therefore, the “net” purchases of securities held outright by the Federal Reserve rose by almost $50 billion over the last four weeks, and rose by about $120 billion over the last thirteen weeks.
As a consequence, commercial bank Reserve Balances at Federal Reserve banks decreased by $28 billion over the last four weeks but rose by around $33 billion over the last thirteen weeks. (Totals don’t add precisely because of other “operating” factors, but these are minor relative to the major changes that I have highlighted.)

The net effect of Federal Reserve operations on bank reserves over these time periods has been relatively minor: consequently excess reserves held by commercial banks remained relatively steady.

On the other hand, the significant QE2 changes in the Federal Reserve’s balance sheet have come in the composition of the Fed’s portfolio of securities held outright. In the last four weeks ending January 5, 2011, the holdings of mortgage-backed securities and Federal agency holdings fell by $31 billion. The Fed’s holdings of U. S. Treasury securities rose by about $81 billion, hence the total amount of securities held by the Fed rose by almost $50 billion, as reported above.

Over the last thirteen weeks, the portfolios of mortgage-backed securities and Federal Agency securities dropped by slightly more than $93 billion while the holdings of U. S. Treasury securities rose by $212 billion. Total securities held outright by the Fed increased by almost $120 billion, as reported above.

I would argue that up to this point in time, quantitative easing has had very little impact on commercial bank reserves and consequently on changes in liquidity or bank lending. Mostly, the Fed has just replaced maturing Federal Agency issues and maturing mortgage-backed securities with Treasury securities. Otherwise, much of the Fed’s operations during this time have been “operational” in nature.

Now, let’s step back a bit, since we are at the beginning of a new year and review what happened to the Fed’s balance sheet over the past year.

Reserve Balances that commercial banks hold at Federal Reserve banks rose by only $9 billion from January 6, 2010 to January 5, 2011. Not much change for all the talk going on about the Fed’s actions.

The question then is “what was the most significant change that took place on the Fed’s balance sheet during the year?”

My post of April 9, 2010 discussed a new strategy for getting reserves into the commercial banking system. This “new” strategy had to do with the creation of something called the U. S, Treasury Supplementary Financing Account. (See my post “The Fed’s New Exit Strategy?”:

Well, the Treasury's Supplementary Financing Account increased by $195 billion in the calendar year of 2010. This account “absorbs” bank reserves, in the same way that moving funds from Treasury Tax and Loan accounts at commercial banks into the Treasury’s General Account at the Federal Reserve transfers bank reserves. Thus, to replace these reserves, the Federal Reserve had to buy securities in the open market to “supply” bank reserves. This, in essence, is “printing money” to substitute for the Federal Debt.

After taking into account other transactions, the Fed supplied about $202 billion in reserves to the banking system which offset a net $193 billion in factors “absorbing” reserve so that commercial bank reserve balances at the Federal Reserve only rose by the $9 billion stated above.

Excess reserves in the commercial banking system actually fell from December 2009 to December 2010 by about $67 billion. Given that excess reserves averaged around $1.0 trillion for most of 2010, the $67 billion drop does not seem particularly significant. The decline did not seem to have much impact either on bank lending or on money market interest rates.

Excess reserves may have fallen during the year because banks needed more required reserve to cover the continued shift in deposits within the financial system from time and savings accounts to demand deposits and other checkable deposits. My last comments on this phenomenon were posted on December 8, 2010: “America Continues to Go Liquid” ( This shift in funds results in an increase in required reserves because banks have to hold more reserves behind demand deposit accounts and fewer reserves behind savings deposits.

It can also be noted that Americans continued to decrease their holdings of Retail Money Funds” (about $30 billion since September 2010) and Institutional Money Funds (about $50 billion over the same time period). Low interest rates and the need to be liquid seem to be dominating the asset holdings of many.

The Fed’s Quantitative Easy in supposed to keep longer term interest rates low so that the economic recovery can accelerate and unemployment can be brought down. The yield on the ten-year Treasury security was around 2.40 percent in early October before the specifics of QE2 were announced. Over the last two weeks this security has been trading around 3.40 percent. Optimists are claiming that this rise in rates is a good sign, a sign that the economy is getting stronger and that inflationary expectations are beginning to grow.

Guess I am not that confident. My experience is that you cannot force long term interest rates below where the market wants them and then maintain them at this lower rate without continually increasing the liquidity being forced into the system. Otherwise, these interest rates will tend to rise of their own volition. At this time I have not seen the Fed actually propping up the financial markets with the “new wave” of liquidity needed to maintain the lower long term rates attained in late summer.

Friday, January 7, 2011

No Peace on European Sovereign Debt

When I read the news coming out of the Eurozone these days I get a very strong sense of déjà vu, all over again.

This feeling comes from hearing over and over again, leaders, whether of nations or of corporations, complaining that “the markets just don’t understand us!”

My response in cases like this is that the markets understand you…too well!

We have been going on and on about the fiscal crisis in Europe for at least a year now. And, things still are unsettled. (See my post “Four Uncomfortable situations to watch in early 2011”,

And, the resulting financial crisis is not because there is not enough liquidity circulating around in world markets. The European Central Bank and the Federal Reserve System have seen to that. (See my post “Is QE2 a Bubble Machine?”,

As evidence of this I point to the fact that Brazil has launched a fresh attempt to limit the appreciation of its currency, “Brazil in Push to Curb Rising Currency”,
And, it is not that Europe is not getting a sympathetic response from other countries. China, especially, has moved to provide funds to purchase sovereign debt. However, China is not that excited about further bailouts.

Still, Greece is continually fighting off concerns about how it is handling its fiscal affairs. (See

And, “Portuguese yields near euro-era high” ( “If Portugal’s borrowing costs keep rising, then the government will reach a point where it will have to seek financial assistance from the international community.”

The major rating companies continue to put out downgrades of government debt and voice their concerns that further downgrades will be necessary. Investors also continue to translate this viewpoint into market prices: “The costs of insuring against a default by Western European sovereign borrowers in the credit default swap market surged, briefly touching a record on Thursday, according to data provider Markit. Swaps prices for Spain, Belgium, and Ireland closed at records, according to Market. The gap between yields on most European sovereign bonds and relatively safe German debt also widened.” (

The fact that this situation still exists after a year of massive efforts by the nations in the European Union and the International Monetary Fund and that lots and lots of money has been spent to resolve the underlying problems indicates to me that somebody is on the wrong page.

Furthermore, given that the situation has not gone away during this twelve month period indicates that the problems have not just been created by the “greedy bastards” known as speculators that have turned against a weakened opponent. If anything the leaders of the European Union have created “one-way bets” that have drawn speculators to feast on their difficulties. (See my post “Interventionists are Setting Up One-Way Bets for Traders”,

My final comment on the behavior of the leaders of the European Union with respect to their sovereign debt crisis goes back to one of my favorite Stephen Covey quotes: “If you think the problem is out there, that is the problem!” It is very easy to pick out people in the investment community as a scapegoat for the problems you experience, especially if you can brand them as “greedy bastards.” Yet, pointing fingers at others and calling others names seldom, if ever, solve problems.

The leaders of the European Union need to face reality. Somewhere, sometime, the value of the debt that is being questioned is going to have to be written down. These leaders are going to have to accept the reality that they did a bad job in managing the responsibilities that they were given.

The process that these leaders are going through now is taking up too much time, is costing too much money, and is drawing the focus of these leaders away from things they really should be dealing with.

My experience is that when things like this are drawn out for such a long time and do not seem to be resolving themselves, it is time to “bite-the-bullet”, admit your mistakes, and move on.

This is a difficult thing to do but it is time to start attacking other problems that need to be dealt with.