Tuesday, May 31, 2011

How Long Will The Bailouts Continue?

How long will the bailouts continue in Europe and the United States? 

As long as the banking systems or large parts of the banking system in these areas remain insolvent.

We wonder about the public officials in Europe and in America and question why they continue to do what they do.

And, what they do only makes sense if their banking systems or large parts of their banking systems are insolvent. 

Jean-Claude Trichet, President of the European Central Bank, went ballistic and recently walked out of a meeting when the subject of restructuring the debt of Greece was brought up.  “On May 24, Christian Noyer, of the ECB’s Governing Council, described the idea of any debt restructuring as a ‘horror story’.  Big losses on Greek government bonds would devastate Greek banks and threaten the health of the ECB, which has been propping up Greece by investing in its debt.” (Bloomberg Businessweek, May 30-June 5, 2011)

“The case for delaying a default is that European banks need more time to repair balance sheets that were devastated by the 2007-2009 financial crisis.  The profits they’re earning now are rebuilding their capital.  The longer that Greece can be kept afloat, the better Europe’s banks will be able to withstand the losses they’ll be forced to recognize if Greece goes under.  European banks and the European Central Bank have a strong incentive to extend and pretend.” 

“Moody’s Investors Service estimates the European banks hold about €95 billion in Greek sovereign and private debt—and could lose one-third of it in a worst case scenario.”  European banks hold some €630 billion in Spanish debt.

If Greece defaults in any way, shape, or form, the question is, “What about Ireland?  And, Portugal?  And, Spain?  And, Italy?  And,…?”

The leaders of the European Union believe that they cannot allow…at this time…any debt restructuring because of the immediate impact it would have on European banks.

This sure sounds like a case of insolvency to me.

And, is the United States in any better shape? 

For at least two years I have been writing that the only way to really understand the behavior of the monetary policy of the Federal Reserve System is to see it as an attempt to keep the banking system liquid enough so that banks can stay open long enough to allow the FDIC to close banks in an orderly fashion. 

Since December 2007, the start of the most recent American recession, the banking system has lost 831 commercial banks through FDIC closure or through FDIC overseeing an acquisition.  From this date through the first quarter of 2011, the banking system has lost about 22 banks per month, which works out to a yearly average of almost 270 banks per year.  Last year, 320 banks dropped out of the banking system and this year we are running at a rate comparable to last year. (http://seekingalpha.com/article/271658-number-of-u-s-banks-drop-by-77-in-first-quarter)  

At the end of first quarter there were still close to 900 commercial banks on the FDIC’s list of problem banks, roughly 14% of the total commercial banks in existence.  So roughly one out of every seven commercial banks is on the problem list.  And, if we believe testimony that Elizabeth Warren gave to Congress last year, we can imagine that at least one out of every four banks in operation are “troubled.”

Should the Federal Reserve, like its sister central bank in Europe, be concerned about the solvency of the banking system?

And, QE2 is scheduled to end in 30 days.  Will there be a QE3? 

My guess is that the employment situation or the growth of the economy will not be the determining factor as to whether or not there is a QE3.  The solvency of the banking system will determine whether or not the policy makers decide for QE3…or some other form of  policy that will provide liquidity to the banking system. 

Can one really claim that unemployment or economic growth is the primary reason for QE2 when over 50% of the reserves the Fed has pumped into the banking system has gone to foreign-related institutions?  And, Mr. Bernanke and other leaders at the Fed, at least on the surface, seem oblivious to this fact.  (http://seekingalpha.com/article/270074-fed-continues-to-pump-reserves-into-foreign-related-institutions-in-the-u-s)

In Europe, the banking structure is somewhat different in that the concern is over big banks for Europe does not have all the small banks that the United States has. 

In the United States the concern for the last two years has been the health of the smaller banks.  That is, in the financial crisis, the Federal Reserve immediately subsidized the largest twenty-five domestically chartered commercial banks in the United States, with roughly 60 percent of the assets in the banking system.

So, the Fed’s main problem, currently, is with the 6,428 commercial banks that make up about 30 percent of the assets of the banking system.  The “problem” banks and the “troubled” banks rest within this part of the banking system.  But, the Fed…and the FDIC…cannot allow these smaller banks to drop out of the system in a dis-orderly fashion.  We are still talking about a pretty large component of the banking system. 

How long will the bailouts continue in Europe and the United States?

Looks like they will continue until the leaders in these areas believe that their banking systems are sufficiently capitalized to absorb the losses that will remain on their balance sheets.

Right now, these leaders do not seem be feel that the banks are sufficiently solvent to absorb such a loss.  

Tuesday, May 24, 2011

The Number of Banks in US Drop by 77 in the First Quarter

The FDIC just released the financial statistics on the banking industry for the first quarter of 2011.

We knew that through May 20, 2011, the FDIC has participated in the closing of 43 banks.  Through the end of the first quarter of 2011, 26 banks had been closed.

With the first quarter results now available we can observe the actual shrinkage in the number of banks in the United States. 

On March 31, 2011 there were 6,453 banks in the United States, 77 less than existed on December 31, 2010.

There were 6,773 banks in existence a year earlier, March 31, 2010, so the banking system has 320 fewer banks at the end of the first quarter this year than one year ago. 

At the start of the recession in December 2009, there were 7,284 banks in the banking system, 831 less independent units than exist at the end of the first quarter of this year. 

The largest drop in banks in the first quarter was in the smallest institutions: there were 51 fewer banks with assets of less than $100 million at the end of the quarter than at the end of 2010.

Banks between $100 million in asset size and $1.0 billion in asset size dropped in number by 34 units.

Banks that had more than $1.0 in assets actually rose as the number of banks in this category increased by 8 banks. 

The consolidation in the banking industry continues.  If the number of banks continues to drop by about 80 banks per quarter, this would mean that the decline in the number of banks in the United States in 2011 would be roughly the same as the decline that took place between March 31, 2010 and March 31, 2011. 

However, the composition of the decline in the number of banks in existence seems to be changing.  Whereas the number of banks that failed in 2010 was about half the decline in the number of banks in existence, in the first quarter of 2011, the number of failed banks was only about one-third of the decline in the total number of banks in existence. 

This would seem to be a healthy development.  The banking system is still expected to shrink, but maybe we have passed the peak of bank failures and most of the contraction in the future will be in consolidations coming through acquisition and merger. 

If the number of banks in the banking system does drop by around 320 this year, that would put the number of banks at about 6,200 on December 31, 2011, a reduction of almost 1,100 banks since the recession began in 2007.

If one of the goals of the Fed’s quantitative easing 2 (QE2) was to provide enough liquidity to the banking system so that the FDIC could close banks with the least disruption possible, then QE2 has seemingly been a success.  The goal of the FDIC, of course, is to close banks in an orderly fashion and the excess liquidity in the banking system may be seen as the means that allowed many of these banks to stay open…especially the smaller ones…before either the bank was closed or an acquirer was found.

Obviously, the banking system is not “out-of-the-woods” yet.  I believe the behavior of the banks indicates the continued fragility of many banks…especially the smaller ones.  The banking system should have begun lending now, almost two years into the current economic recovery.  Yet the banks continue to “hold on” to the reserves the Fed in pumping into the banking system.  Excess reserves are closing in on $1.6 trillion…with still only modest increases in lending…and this increase is just coming in the largest 25 banks in the country. 

I am still seeing only 4,000 banks or less in the United States banking system in the relatively near future.  I believe that the financial condition of domestically chartered banks in the United States, the movement of more foreign banks into the United States banking system, and the changes that are taking place in the use of information technology in the banking system are going to result in a continued decline in the number of banks that exist.     

I do believe that this re-structuring of the banking system will result in a stronger and more vibrant banking system, one prepared to compete in the twenty-first century.  The transition to this “new” system, however, is slow and tenuous.  Tenuous, because creating a “new” banking system, one that is much more technologically advanced will not come about easily…especially given the road blocks the politicians and the regulators will put in the way of the evolving system. 

Debt Ultimately Leaves You With No Good Options

The economies of Europe are hurting, unemployment is too high, and the social nets are under attack.  The economy of the United States is hurting, unemployment is too high, and the social net is under attack.

Options for the governments in each area are decreasing and despair is growing. 

This is exactly what piling on the debt eventually does to you.

I sympathize with the unemployed.  I sympathize with the under-employed.  I sympathize with the labor unions…public sector and private sector…that are losing members and popular support.  I wish there were more for everyone.

Taking on debt, in the beginning, looks like it frees one up…provides opportunities to do more things…own more things…live a better life. 

Eventually, debt does exactly the opposite…limiting your options…constraining your life style…and exerting pressures that are unwelcome.

I sound like a preacher from the early part of the twentieth century…don’t I?  This is exactly what they used to say. 

Except this is just what we are seeing. 

Taking on debt in the early stages of financial leveraging does allow you to do some things that you cannot do without debt.  And, in these early stages, more debt can seemingly “buy” you out of difficulties. 

As we have seen, more debt then becomes the solution to the problems created by debt.  And, it works for a time.

The thing that people don’t see in continually using debt as a panacea for their problems is that the more and more debt they add to their balance sheets, the fewer and fewer options they have. 

Finally, the obligations created by the debt result in a reduction in the options leaving the debtor with very few choices…and, with most of the choices undesirable ones.

So, the government of Greece is faced with selling assets, and tightening up its budget even further, reducing government employment, and cutting social services. 

Portugal is now under the knife although it believed for a long time that it would escape the “cure”.

And, who are becoming the hard-nosed critics that are pushing these governments to take on more radical solutions?

Spain…and Italy…and Belgium….

Why?  Well, because these latter countries are now feeling the potential for the “contagion” to spread in the European continent. 

Spain, who seemed to be getting its house in order, observed a massive shift in voting on Sunday as the long ruling socialist party was basically removed from office.  There is great fear that the accounting in regional governments has been understating the debt of the country and this will have to be recognized and dealt with by the incoming governments.  Whoops!

Italy has a national debt equal to 120 percent of its gross domestic product and is experiencing sufficient economic dislocations that its future was called into question by a bond rating agency.

Belgium is now also coming up on the radar screens of the investment community.  The interest spread on 10-year Belgium debt over 10-year German debt jumped to a near term high on Monday.  Belgium, too, is looking anxiously at what Greece…and Portugal…do to avoid becoming one of the falling dominoes.

Yet there are still calls for these countries to increase their spending and create more debt to solve the employment and social services problems for the countries experiencing such suffering.

Foremost among those calling for more spending and more debt is the fundamentalist preacher Paul Krugman.  To him more debt seems to be the solution to any problem an economy faces. 

Yes, people are hurting, but, as he seeks to achieve a reduction in the “official” unemployment rate, some of us see the increase in the under-employment of our workforce throughout the past fifty years, the period of credit inflation, as the consequence of those, like Krugman, who profess the gospel of governmental deficit spending as the way to put people back to work in their legacy jobs.

Krugman criticizes those concerned with the massive debt levels achieved by  European governments…and by the United States government…and claims that those worrying about these debt levels are like some that are claiming that the end of the world is near.

Yet, Krugman, himself, sounds like a profit of doom, when he claims that the world as we know it will end if governments don’t increase spending and create more debt!

The problem we now face is one in which there seems to be very few choices left for us.  The amount of debt that people and nations have created is acting like a noose around our neck that is getting ever tighter.  We can do as Krugman suggests, and goose up stimulus spending some more creating more debt, but, as we have seen, the outcome of this would be to provide us with even fewer choices in the future.  The noose will just get tighter.

Eventually, the options will run out, leaving us no choices.

It seems to me that we must deal with the choices that are now available to us, even though they may not be very pleasant ones, and act in a way that will allow us more and better choices in the future.  If reducing the debt outstanding at this stage is the only way we to increase our options, then it seems as if this is the way we must go. 

Given the limited choices that are available to us at this time…I would hate to see our options become even more constricted.         

Monday, May 23, 2011

The Consequences of Debt Are All Around Us

Why isn’t the economy expanding at a faster pace?  Why aren’t consumers spending as robustly as they have in the past?  Why aren’t banks lending?

The answer has to do with either the debt still on the balance sheets of businesses, banks, and households, or the remains left by the debt that was created over the past fifty years.

We see the consequences of the half-century debt binge posted all over…on the Internet, in newspapers, and on radio and television.  Lots and lots of debt or the results of debt everywhere. 

Of course, the Greek debt situation is all over the papers this morning  In addition, the Socialists lost control of many local governmental bodies in Spain on Sunday, giving rise to fears that large amounts of unrecorded debt in many of these units will be discovered as a result of the change in government. (http://seekingalpha.com/article/271083-the-global-economy-debt-and-accounting-gimmicks)   

State and local governments in the United States are offering thanks that the media attention has shifted from them to the European entities.  But, the debt problems of state and local governments will not go away…so just wait!

The most important news this morning, to me, is the attention given to the banking systems of both Europe and the United States.

The headline in the Wall Street Journal proclaims, “Buyers Battle for Europe’s Bad Loans,” (http://professional.wsj.com/article/SB10001424052748704083904576335510788215984.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj) “The push by banks across Europe to clean up their balance sheets is causing a feeding frenzy among hedge funds and private-equity firms hungry for their troubled assets.”

“Banks from the U.K., Ireland, Germany, Austria, Greece, Italy, Portugal and Spain have been unloading tens of billions of dollars worth of assets…”

Marathon Asset Management LP, for example, is reported to have purchased bank assets “usually in batches of $25 million to $100 million, at discounts of as much as 50% of their face value.” 

“European banks are sitting on more than 1.3 trillion ($1.9 trillion) of loans that are considered ‘non-core’ to their businesses and are likely to be put up for sale over the next decade.”

“In the U.S., a similar process has been going on for years…Until recently, European regulators generally were content to let their banks work through their problems over time.” 

Europe’s sovereign-debt crisis put an end to that!

The point is that there is still a “ton” of debt “out there” that is being written down or is going to be written down and still has to be “worked out.” 

In other words, the economies of Europe and the United States are not fully out-of-the-woods.

The “working out” part of this statement is captured in the New York Times headline, “Banks Amass Glut of Homes, Chilling Sales” (http://www.nytimes.com/2011/05/23/business/economy/23glut.html?_r=1&hp). “The nation’s biggest banks and mortgage lenders have steadily amassed real estate empires, acquiring a glut of foreclosed homes that threatens to deepen the housing slump and create a further drag on the economic recovery.”

“All told, they own more than 872,000 homes as a result of the groundswell in foreclosures, almost twice as many as when the financial crisis began in 2007.” 

“The pileup could lead to $40 billion in additional losses for banks and other lenders as they sell houses at steep discounts over the next two years…”

And, this problem is extended to other areas of the real estate market like the commercial real estate sector. 

The good news…”the number of new foreclosures and recent borrowers falling behind on their payments by three months or longer is shrinking.”

Where is the focus of the banks?

The focus is more on attempting to minimize the amount of write down the banks must take and is not on generating new loans to build up revenue streams.  Right now, the balance of effort in banks seems to be on the side of keeping down charge-offs because of the larger impact on solvency, rather than just on earnings.  In fact, the recent increase in bank earnings has been largely due to a reduction in loan charges rather than an increase in revenues. 

If we are to get the focus of banks back on lending and on supporting economic growth we must get through this period of restructuring the balance sheets of commercial banks to remove the bad assets.

But, this presents a problem to the policy makers in Washington, D. C.  If commercial banks, and other economic bodies, must work through their debt problems before they can focus on increasing loans and increasing spending, efforts to stimulate the economy through further governmental credit inflation will have little impact on picking up economic growth.

This factor is not considered in most macro-economic models because the importance of debt on business decision-making will vary from time-to-time.  At lower levels of indebtedness, economic units may not feel that they have to restructure their balance sheets to reduce debt loads and further fiscal stimulus, more credit inflation, will bring about more rapid economic growth.

However, in periods when the burden of the debt loads become too heavy, people will need to re-adjust their behavior and reduce levels of financial leverage to more reasonable amounts.  At these times, further fiscal stimulus, more credit inflation, may have only a modest impact on economic growth.  In situations like these, fundamentalist preachers like Paul Krugman may cry all they like about the need for more and more governmental spending, but even that will not bring on “the Rapture.”

We are in a period when the excesses of the credit inflation of the past must be worked off before people can begin to fully focus again on the future.  The economy is highly bi-furcated, both in Europe and in the United States.  Those people and institutions that are not highly leveraged and have cash-on-hand, will prosper relative to those that are highly leveraged and are short on cash.  The last fifty years has seen a tremendous skewing of the income and wealth distribution in the United States toward the richer end of the spectrum.  My guess is that, given the current situation and the current economic policies, this trend will continue.  Maybe debt is not such a “good thing” after all.      

Friday, May 20, 2011

Debt and Accounting Gimmicks

Isn’t it interesting that highly leveraged institutions and organizations seem to bring out very innovative accounting strategies?

It is in times like these that were learn just how creative accountants can be. 

“Weekend elections that threaten to drive Spain’s ruling Socialist party from power in several regions and cities also promise a potentially nasty surprise: the revelation of piles of undisclosed debt in local governments that could undercut the country’s drive to avoid an international bailout.” (See “Spain Vote Threatens to Uncover Debt,” http://professional.wsj.com/article/SB10001424052748704281504576331280001740702.html?mod=ITP_pageone_2&mg=reno-wsj.)

“Five months ago, a government change in Spain’s Catalonia region revealed a budget deficit more than twice as big as previously reported.  Now a growing chorus of economists, local politicians and business leaders say that new governments are likely to discover, as Catalonia did, piles of ‘hidden debt’ owed to health clinics and other suppliers.”  It is suggested that “there is widespread, unrecorded debt among once-free-spending local governments.  Some companies are complaining that fiscally frail administrations are pressuring them to do business off the books and not immediately bill for goods and services…”   

“Such bills could add tens of billions of euros to the official debt figures reported by local and regional governments.  If such skeletons come out of the closet in coming weeks, Spain’s cost of funding could continue to rise—throwing the country back into the limelight after it has struggled to demonstrate it doesn’t need to be bailed out like Greece, Ireland, and Portugal.”

Wait a minute…didn’t the renewal of concern over the debt situation in Greece come about because it was discovered that the amount of debt owed by the Greek government was worse than had been previously accounted for. 

We don’t need to just keep picking on European states.  What about state and local governments in the United States?  Pension funds grossly underfunded?  Off-balance sheet financing?  And more?

But, why stick with governments?  What about Lehman Brothers?  What about AIG?  What about Citigroup?  The amounts of off-balance sheet tricks used by these organizations fill the current library of books about the recent financial crisis.  The story is about CDOs and SUVs and so forth.  Trying to disguise liabilities is not just a gimmick of the public sector. 

To me, however, this mis-accounting goes even further.  The question really is one about where do you draw the line.  That is, what types of accounting efforts are meant to evade discovery and hence are not exactly kosher…and which ones are of little or no harm? 

For example, how do you value an asset on the balance sheets of financial institutions?  If you hold a marketable security you must be concerned with the liquidity of that security when valuing the asset.  If interest rates rise and the market price of the security goes down, do you mark-to-market the value of the security on your balance sheet?  If the security is a part of the trading portfolio of the institution then the general answer is that the value of the security on the balance sheet should be marked down.

But, if the institution bought the security to hold then the question becomes more difficult for some people to answer because the intention is to hold the security to maturity at which time the full amount of the principal would be repaid to the institution.

Now, what if the credit quality of the security comes into question?  There are really two questions here: the first has to do with the credit quality of the security; the second has to do with the liquidity of the security?  If the credit quality of the security declines, then, given the value of the asset should decline…its price should fall.  Thus, the market price of the security should decline.  However, if the market is uncertain about how to price the asset, given the decline in its quality, the market for the security may “dry up” and the security may not be able to be sold immediately.

Thus, the value of the asset on the balance sheet should be adjusted downward, but without any market judgment about what the price of the security should be…how do you determine the amount the asset should be written down?

Here we have a problem that was addressed by the US government’s Troubled Asset Recovery Program (TARP) during the financial crisis.

Many in the financial industry have argued that the assets should not be marked-to-market in such cases because there is really no market for the asset.  Hence, these securities should be retained on the balance sheet at book value.

Now, what about the direct loans a financial institution makes?  Almost all of these do not have markets in which they can be sold.  So, the loans are totally “illiquid”.  Furthermore, bankers consider that most of the problems the borrowers face are “cyclical” and all that is needed when economic times are not good is for the economy to improve and the loans will work themselves out.  That is, the financial institutions must hold the loans “to maturity” and, thus, they can be held on the balance sheet at book value. 

The question is…what should be the accounting treatment of these assets of financial institutions?

Of course, this problem only occurs during bad times after most of the economy has become excessively leveraged and loan value are under attack.  For example, currently, in terms of residential real estate loans, mortgages, we see that seriously delinquent loans (90 days or more delinquent) are declining but still near historic highs, the number of borrowers in foreclosure remain near record highs, and the sale of houses and housing prices continue to decline. (http://professional.wsj.com/article/SB10001424052748704816604576333222700445278.html?mod=ITP_moneyandinvesting_1&mg=reno-wsj) The commercial real estate area remains depressed.  The loans of these two kinds of loans continue to plummet. (http://seekingalpha.com/article/270074-fed-continues-to-pump-reserves-into-foreign-related-institutions-in-the-u-s)  But, has the status of these loans been changed on the books of the banks?

The concern, in these cases, is not with the liquidity of the asset.  The concern is with the solvency of the financial institutions.  Have accounting practices not given investors…and others…a true picture of the financial condition of the institutions under review? 

My concern in all these cases is that we really don’t find out the truth until too late…until it is “after-the-fact.”   Then we blame speculators or others, who take advantage of the situation, of preying on the innocent, of creating the crisis, and, of course, we don’t want to reward speculators. (http://professional.wsj.com/article/SB10001424052748704904604576333393150700686.html?mod=ITP_pageone_2&mg=reno-wsj)  

The bottom line: the pressure to use accounting gimmicks to cover up the “real picture” grows as high degrees of leverage come to dominate an economy.  This is because debt requires contractual payments.  Debt requires an obligation and a responsibility. 

And, so we see a pattern.  Just as credit inflation is the foundation for greater risk-taking, higher degrees of leverage, and more financial innovation, we see that greater risk-taking, higher degrees of leverage, and more financial innovation is the foundation for more creative accounting practices. 

In both cases, we all ultimately lose in the end!

Thursday, May 19, 2011

Making the Same Mistakes All Over Again

Policy makers continue to base their economic and monetary policies on the contention that the problems “out there” are liquidity problems…not solvency problems.  This focus is highlighted in three articles in the morning newspapers. 

The most direct treatment of this is that of Desmond Lachman of the American Enterprise Institute, “The IMF is making the same mistake all over again”: http://www.ft.com/intl/cms/s/0/b2f38dd2-8195-11e0-8a54-00144feabdc0.html#axzz1Mnj4kmN5.

Mr. Lachman makes the argument that the policies followed by Dominique Strauss-Kahn and the IMF with respect to the sovereign debt crisis in Europe is that they have treated “the crisis as a matter of liquidity rather than solvency…” The consequence of this approach is that this philosophy has “led the IMF to eschew any notion of debt restructuring or exiting from the euro, as a solution to the periphery’s public sector and external imbalance problems.”

In another article, Scott Minerd, chief investment office at Guggenheim Partners, argues that “There will Be More Monetary Elixir After the End of QE2”: http://www.ft.com/intl/cms/s/0/96ec2b02-8146-11e0-9360-00144feabdc0.html#axzz1Mnj4kmN5. 
The motivation for QE3? “The same motivation for QE1 and QE2: namely, stimulating growth to help employment recover…Looking ahead, the expiration of tax cuts in 2011 and a government deficit reduction program will present real headwinds to growth.  Layer on top of that the fact that 2012-13 would probably be the end of the expansionary portion of the business cycle, and what is left is a recipe for a serious economic slowdown or possibly even another recession.”

And, finally, there is Alan Blinder’s opinion piece “The Debt Ceiling Fiasco,” http://professional.wsj.com/article/SB10001424052748703421204576329374000372118.html?mod=ITP_opinion_0&mg=reno-wsj.  To stay within the debt ceiling, Mr. Blinder argues, the government must immediately drop it expenditures by 40%. “Suppose the federal government actually does reduce its expenditures by 40% overnight…That’s an enormous fiscal contraction for any economy to withstand, never mind one in a sluggish recovery with 9% unemployment.” 

“Second, markets now assign essentially zero probability to the U. S. losing its fiscal mind.”  That is, the credit risk built into U. S. government securities is zero and the inflationary expectations that are now built into long-term interest rates are also roughly zero. 

And, what has allowed the United States to get into this position?  Well, “The full faith and credit of the United States has been as good as gold—no one has better credit.”  The federal government has been allowed to increase its debt at an annual compound rate of growth of about 8%, year-after-year for the last fifty years.  “Should the view take hold that threats to default are now a permissible weapon of political combat in the world’s greatest democracy, U. S. government debt will lose its exalted status as the safest asset money can buy—with unpleasant consequences for the dollar and interest rates.” 

That is, the United States government will lose its unlimited privilege to flood the world with debt and liquidity at little or no consequence to itself.
All three of these articles are concerned with the view that the basic problems of the economy have to do with liquidity…and not solvency.

I have argued for several years now in this blog that this has been a major problem in the analysis of the economy and the current financial difficulties we are now going through.   Right from the start of the current unpleasantness, the problem has been diagnosed as a liquidity problem and not a solvency problem.  The TARP program was designed to give liquidity to certain “troubled” assets on the balance sheets of various financial institutions.  QE1 was designed to provide liquidity to banking and financial markets.  So was QE2.  So were the bailout programs, both in the United States and Europe. 

But, liquidity problems have historically been considered to be “short-term” problems.  They have to do with whether or not an asset can be sold into the current market in real time without having to take a discount from market on the price at which it is sold.  In the past, a liquidity crisis should be over, given the appropriate monetary policy, in a matter of weeks, six- to eight-weeks at most. 

Liquidity problems did not and do not exist for three or four years!

Yet, this is what our policymakers are claiming.  They are claiming we are still in the midst of a liquidity crisis and so we must tailor our monetary and fiscal policies to deal with the lack of liquidity in financial markets.

The reason for this approach?  The models that these policymakers and their advisors are using only include debt in a cursory fashion.  The structure of conventional macroeconomic models over the past fifty years has not included debt in any meaningful way and so the existence of large amounts of debt has not really been relevant for analysis.  And, consequentially, the solvency issue does not surface.  

The focus then is placed on the “liquidity” issue, the desire of economic units to want to hold onto cash assets.  If banks and other economic units desire to hold onto cash rather than lend the funds to others or to spend the funds themselves then the economic will falter and economic growth will be tepid at best leading to high rates of unemployment.  This is a “liquidity trap.”

The solution to this problem is to flood the banking and financial markets with so much liquidity that people just can’t hold on to any more liquidity and so either begin to lend the funds or begin to go out and spend the funds themselves.  This seems to be the current thrust of economic policy, at the Federal Reserve…and throughout the world. 

But, what if a large number of economic units are insolvent.  In such cases, even with large amounts of liquidity on their balance sheets, they will not lend, or will not borrow any more, or will not go out and spend this excess liquidity because of their balance sheet problems.  What about homeowners who find that they cannot pay their loans or find that the value of their home is less than what they have borrowed?   What about banks who hold large amounts of delinquent residential mortgages or commercial real estate loans on their balance sheets?  What about businesses that owe way too much debt and have little or no current cash flows to cover the debt?  What about State and Local governments that have obligations far in excess of their current revenues?  And, what about sovereign nations who face similar problems?

If the problems are ones of solvency, liquidity is going to do very little for those who have a negative net worth other than postpone the day of reckoning. 

This is the problem of debt.  America (and Europe) has done a very good job over the past fifty years of inflating people, organizations, and governments, out of their increasing debt burdens.  The inflation of housing prices was a wonderful “piggy bank” for the middle class during this time period.  Maybe, the United States government went a little overboard in trying to push down this “piggy bank” to more and more people who even with the inflation could not support the debt.  The credit inflation did wonders for building up the salaries and pension funds of state and local governments.  Unfortunately, history shows over and over again that there are limits to the amount of debt people can carry.  But this is a solvency problem not a liquidity problem.

Finally, a country whose “faith and credit “ is as “good as gold” can abuse that privilege.  This, too, is a solvency problem and not a credit problem.  And, as we are finding out…once again…solvency problems cannot be postponed forever.      

Monday, May 16, 2011

We Shouldn't Be Concerned About Inflation? Really?

The Federal Reserve continues to argue that Americans should not be worried about inflation.  The recent bumps in the Consumer Price Index, we are told, are just temporary, being caused by special circumstances in the world, particularly affecting food and energy prices. 

The problem I have with this is that the information about inflation keeps getting worse…and not just in the United States. 

In the United States we see that the year-over-year rate of increase in the Consumer Price Index has established the following trend starting in November 2010: 1.4%; 1.7%; 2.2%; 2.7%; and, finally, in April 2011, 3.1%. 

And, the increases in the overall index also include increases in the major component of the index, the owner’s equivalent rent component of the housing price index, as follows over the same period of time: 0.2%; 0.3%; 0.5%; 0.6%; 0.8%; and finally, in April 2011, 0.9%.

These estimated “rental” numbers, obviously, help to keep the overall Consumer Price Index from rising too rapidly.    

But…everything is moving up!

And the world?

This morning the headlines read, “European Inflation Rises to Fastest in 2 ½ Years,” (http://www.bloomberg.com/news/2011-05-16/european-inflation-rises-to-fastest-in-2-1-2-years.html).  And, Jean-Claude Trichet, the President of the European Central Bank, is envisioning higher bank rates in the future.

In India, ”Wholesale Prices in India Rise 8.66 Percent in April From Year Earlier,” (http://www.bloomberg.com/news/2011-05-16/wholesale-prices-in-india-rise-8-66-percent-in-april-from-year-earlier.html), and, the Indian government is seeking higher interest rates.

In China (http://www.bloomberg.com/news/2011-05-16/china-stock-index-futures-fall-on-inflation-greece-concerns.html) the Chinese government has raised interest rates and increased the required reserves in the banking system.

Meanwhile, the Federal Reserve System in the United States continues to flood the banking system with excess reserves, 50 percent of these reserves ending up as cash assets in foreign-related financial institutions within the United States (http://seekingalpha.com/article/270074-fed-continues-to-pump-reserves-into-foreign-related-institutions-in-the-u-s).  The Fed seems to be underwriting the “carry trade” throughout the world.

How can inflation not be in our future?

Commercial banks in the United States are sitting on $1.6 trillion in cash assets…excess reserves, if you will. 

The Federal Reserve is pushing to help the Obama Administration reduce the unemployment rate!  And, the Fed does not seem to want to back off of this objective.

The Fed is encouraged because business loans, commercial and industrial loans, at the biggest 25 commercial banks in the United States finally seem to be increasing giving some hope that businesses will start hiring people at a faster rate in the future. (See my post from yesterday, mentioned above.)  So, monetary policy seems to be starting to work.

But, the momentum of economies is slow to gain speed and this momentum is slow to contain once it has begun. 

The fear in the developing countries is that the economic momentum is “too hot” and needs to be brought down.

The fear in the developed countries is that stagflation is going to take over…the momentum will take place in prices while inflation will not be combated to any degree because of the employment concerns. (See “Threat of Stagflation Rears Its Head”: http://www.ft.com/intl/cms/s/0/21d6545c-7d89-11e0-b418-00144feabdc0.html#axzz1MWF5W9Ov.)

We shouldn’t be concerned with inflation?

I don’t think the American government in its current state of mind can live without credit inflation.  The habit is too imbedded in the political psyche.  

The federal government has underwritten credit inflation for the past fifty years.  As a consequence, the public debt of the United States government has increased at a compound rate of growth of about 8 percent over the last fifty years.  Credit market debt has risen by more than 10 percent per year over the same period of time.  These rates of increase are not slowing.

Inflation will come in one way or another because there is no end in sight of the current attitudes toward debt creation.

Fed Continues to Pump Reserves into Foreign-Reated Institutions in United States

Over the past thirteen week period the Federal Reserve has pumped roughly $350 billion of excess reserves into the banking system. 

From February 2, 2011 to May 4, 2011, cash assets at commercial banks rose by $400 billion.  (Cash assets at commercial banks can serve as a rough proxy for the measure excess reserves.)   

During the same time period, $306 billion of the $400 billion increase in cash assets of commercial banks in the United States went to foreign-related financial institutions.

On May 4, 2011, of the $1,586 billion of cash assets in commercial banks in the United States, 50%, or exactly half of these cash assets, resided on the balance sheets of foreign-related financial institutions.   

The quantitative easing of the Federal Reserve continues to support, in large part, the “carry trade” where funds generated in the United States continue to find their way into foreign markets. 

Over the past four-week period, cash assets at all commercial banks actually declined by about $9 billion.  However, cash assets at the foreign-related institutions rose by $27 billion during this time period while cash assets at the largest 25 commercial banks in the United States fell by approximately $21 billion and they fell at smaller domestically chartered United States banks by $14 billion.

There is some good news, however!

The good news is that business loans, commercial and industrial loans, at commercial banks really seem to be on the up swing.  Over the past thirteen-week period, C&I loans have increased by $35 billion.  Roughly two-thirds of this increase, or about $23 billion, of the loans came from the largest 25 banks in the country.  However, C&I loans were only up modestly at the smaller commercial banks over this period. 

In the past four-week period business loans were up $10 billion and 60 percent of these, or $6 billion, came from the largest banks.  Again, C&I loans were up at the smaller institutions by a modest amount. 

So, banks, especially the larger banks, seem to be lending again to business, something that is vitally needed if the economic recovery now under way is to really pick up. 

If the goal of the Federal Reserve in conducting QE2 was to get business loans increasing again, then it seems to have succeeded.  Sure, we will have to wait a little longer to get more confirmation of this trend, but this is the first time in this cycle that business loans really do seem to be increasing.

The not-so-good news: the volume of real estate loans on the books of commercial banks continues to tank.  Over the past thirteen-week period, real estate loans at all commercial banks dropped by almost $90 billion.  Over the past four-week period, these loans declined by over $18 billion. 

Almost all of the decline has come at the largest 25 domestically chartered banks in the country.

Over the past thirteen weeks, the major part of the decline came in the area of residential loans ($41 billion), which was closely followed by the fall in commercial real estate loans ($34 billion).  In the past four weeks, the bulk of the decline came in the residential area ($12 billion). 

So, business loans appear to be picking up but the real estate market continues to decline: mixed signals for any sustainable economic recovery.

Maybe, however, this is all the Federal Reserve hoped to achieve at this time.  It seems as if almost everyone believes that it will still be a while before the real estate markets, both residential and commercial, bottom out and start to pick up steam. 

Maybe all the Federal Reserve thinks it can do is to get businesses borrowing again and with that borrowing put some people back to work.  And, it seems that if the Fed can achieve this small win it would think that flooding the rest of the world with United States dollars has been worth it.   

It would be too bad if a substantial part of the uptick in business lending was just going to finance the merger and acquisition activity of large businesses: http://seekingalpha.com/article/269056-the-latest-merger-binge-and-the-economy.