Thursday, September 29, 2011

Wanna Chance to Double Your Money in 30 Days?

Why do large investors…hedge funds and others…like governments to get involved in financial affairs?

Because these investors can make lots of money from the actions of these governments. 

Ask George Soros about the behavior of the British government in the 1990s.

Now we have another possible piggy-bank on the horizon…thanks to the Greek government and the Eurozone.

“Under the deal Greece struck in July with its banks as part of Europe’s rescue plan, a substantial portion of its existing bonds are scheduled to be swapped into new longer-term securities that could be valued at more than 70 cents on the euro.” (,%20despite%20risk&st=Search)

Why is this “deal” important?

Many Greek government bonds “are changing hands for as little as 36 cents for each euro of face value.” 

Making money on this deal requires that the latest Greek bailout system is ratified by the parliaments of the 17 European Union countries that use the euro by late October. 

If the EU deal closes, “those who bought the bonds recently at distressed prices might in some cases come close to doubling their money.”  And, in only one or two months time!

Again, investors benefit…taxpayers suck it in…

“According to a person with direct knowledge of the debt swap, about 30 percent of the investors who are expected to participate in the (deal) bought their bonds after July 21.  They are not the original debt holders…”

What governmental “leaders” don’t seem to understand is that once they take a position, many other people in the world will change their positions to take advantage of the new position of the government.  Things just don’t stay the same.  And, if these “leaders” follow the same strategy over and over again…others will take advantage of the repeat strategy and use it against the “leaders”.

In the case of the European Union, the “leaders” of the EU have tried repeatedly to “kick the can” down the road.  By failing to take action in the past, these “leaders” have postponed the actions that must take place.  But, by postponing and postponing the day when the actions will take place, the “leaders” have just limited their options and created situations in which large investors can take advantage of the dislocations that have developed in financial markets. 

If the “leaders” had been leaders and had moved earlier when the dislocations in the financial markets were smaller, such possible large returns would not have been available.  By postponing action, these “leaders” allowed the situation to get further “out-of-line” and this results in the possibility of well-placed investors making lots and lots of money. 

Of course, the bailout must go through…and this is the risk that these investors face. 

And, the fate of the taxpayers?

“Defenders of the (deal) say that while it may not be ideal, it was the best deal that could be reached at the time.  If hedge funds make some money along the way, they say, that is a small price to pay for securing a contribution from the private sector.” 

An investment tip…look for dislocations created by government actions. 

Another place where lots of money was made recently was on French banks.  Why?  Well, because French banks…and other European banks…have been given special treatment in the past and the problems relating to European sovereign debt have been handled, well, inconsistently…at best.  And, then there were the “stress tests” given the European banks which proved to be a joke. 

The stock prices of French banks had to decline and with this decline the rating agencies lowered the ratings that were given to the banks exacerbating the decline in their stock prices.  The article cited above begins its discussion of hedge fund purchases of Greek bonds by stating, “After a number of investors struck gold by betting against French banks…”

Lots of money will be made from the European financial crisis.  Lots of money will also be lost.  The money made will tend to go to the better off who can “bet” against the governments.  Postponing actions to protect the “less well off” only seems to lead to situations where the benefactors of the ultimate actions of the government are not the ones the “leaders” of the government are trying to help.

As I have stated many times, Europe has gotten into the current situation by assuming that its sovereign debt problems were problems of liquidity and not solvency.  People tend to avoid as much as possible questions relating to solvency.  This is especially true of bankers and the assets that reside on their balance sheets. 

Solvency problems, however, cannot be postponed forever…they must eventually be dealt with.  But, this is where real leaders must step up.  Identifying solvency problems earlier rather than later is always a benefit.  Identifying solvency problems earlier let you deal with the issues surrounding the asset sooner when the problems are not so severe.  Dealing with solvency problems earlier rather than later allow one to make smaller, incremental adjustments that the institution…or country…can more easily absorb. 

People…especially politicians…don’t like to admit mistakes and so we declare that the problems we face are liquidity problems and not solvency problems and we postpone the day of dealing with them. 

Such postponements can only result in opportunities for others.  Wanna chance to double your money?        

Tuesday, September 27, 2011

An Economic View from the Supply Side

As I have written before, the United States economy is recovering.  It may not be recovering as fast as some would like, but economic growth is positive.  Economic growth is not as rapid as some would like because there is still a massive debt overhang that must be eliminated, one way or another.

Furthermore, unemployment and under-employment are not dropping as fast as some would like.  The labor market is not improving with any speed because the economic policies of the last fifty years has resulted in a large amount of the United States manufacturing capacity being unused.  As physical capital is unused so is human capital.

Both of these situations took a long time to get to their present state and will take a long time to regain higher levels of economic growth, capacity utilization, and employment. 

The background for this situation can be examined from the following chart.

  This chart contains a graph of real Gross Domestic Product beginning in 1960 and ending in 2010.  I start with the year 1960 because that is the year before the United States government, both Democratic and Republican, introduced a “new” economic philosophy into its policy considerations, one that emphasized the inflation of credit throughout the economy. 

To me, the important thing about this chart is that real GDP is almost continuously rising.  Yes, there is a sizeable bump at the far right-hand side of the chart, and this is associated with the Great Recession, an apt title.  Otherwise, there are other little deviations from the upward trend, but these are relatively minor movements along the way.

This is where I take my stand with the economic growth proponents.  In the United States economy, growth is almost always positive.  The annual compound rate of growth for the period covered in the chart is 3.1 percent.  The annual compound growth rate of the United States economy, ending the calculation in 2007 (the Great Recession began in December 2007) the rate of growth rises to something around 3.25 percent.  But, growth is dependent upon the private sector, not directly on the government.    

I define credit inflation as a period in which the rate of growth of debt in the economy exceeds the rate of growth of the economy.  Over the past fifty years, the debt of the United States government has increased by more that a 7.0 percent annual compound rate of growth.  The debt of the private economy has risen in the range of 11.0 to 12.0 percent every year.  This meets my definition of credit inflation because these growth rates are far in excess of the rate of growth of the economy. During this period, the purchasing power of the dollar declined by about 85 percent.  In other words, a 1960s dollar could only buy 15 cents worth of goods and services today versus a dollar’s worth in 1960.

Side note on credit bubbles: when the annual compound rate of growth of the debt being created in a subsector of the economy exceeds the annual compound rate of growth of the economic growth of the subsector, a credit bubble can be said to exist.  The housing market bubble of the early 2000s fits this definition.

Credit inflation can have a detrimental impact on economic growth.  Credit inflation creates incentives that cause manufacturers to move away from the producing of goods and to move into the creation of finance.  Two examples of this are GE and GM: for example a couple of years ago GE was earning more than two-thirds of its profits from its finance wing.  In terms of the whole economy, there has been a huge swing over the past fifty years from the manufacturing sectors of the economy to the financial services sector of the economy.

Some of the consequences of this re-allocation of capital is that the employment of capital declined: capacity utilization is around 77 percent now relative to more than 90 percent in the 1960s.  Under-employment is over 20 percent now and was under 10 percent in the 1960s.  And, the income/wealth distribution is more skewed toward the wealthy than it was 50 years ago.

This has impacted economic growth.  For example, the annual compound rate of growth of real GDP has only been 2.5 percent over the past twenty years, down substantially from the rate of growth for the whole period.  Credit inflation, as an economic policy of the government, seems to have exactly the opposite impact on the economy that is desired by policy makers.

But the other important thing to notice in the chart is the “bumps in the road”.  In my opinion, all of these “bumps” resulted in some way from dislocations in the growth of credit instruments as a result of the monetary or fiscal policies of the United States government.  In most cases, the dislocations were relatively minor. However, as the debt load expanded and the private sector devoted more and more resources to financial services, the ability to carry the load grew greater and greater.

The debt burden cannot keep growing: it has to collapse sometime and along with it the economy.  In most cases the “bumps” were relatively minor.  I know it is never fun for anybody to be un-employed or under-employed, but in the aggregate sense, the “bumps” were not large. 

During the Great Recession and following, the “bumps” were much larger because the build-up of the debt dislocations were greater than ever.  However, since the debt burden must be worked off, it will take more time for the economy to achieve the longer run rates of growth that were achieved earlier in this fifty years of economy prosperity.  But, it will come. 

We must be aware of these dislocations and the things that must be done to re-structure the economy and get back to the economic growth performance we are looking for.  For example, we cannot ignore the state of the banking industry in this recovery. (See my post from last Friday:  Resolving the “bumps” just means that the previously created dislocations in finance and economics must be resolved.    

Friday, September 23, 2011

Why Banks Aren't Lending

Remember the old story about commercial banks?  Commercial banks only lend to people who don’t need to borrow.

Well, that seems to be the “truth” about bank lending now.  The story going around is that the larger banks have increased their business lending, but the lending is really only going to those institutions that have a lot of cash on hand.  Otherwise, the commercial banks will sit on their excess reserves.

This also seems to be the story in Europe: commercial banks are just not lending anywhere. (

And, the relevant question is not “Why aren’t commercial banks lending?”  The relevant question is “Why should commercial banks be lending at this time?”

The first reason why many banks shouldn’t be lending right now is that there is still a large number of banks who may be severely undercapitalized or insolvent.  Many commercial banks have assets on their balance sheets whose economic value is substantially below the value the asset is accounted for on that balance sheet.

The most notorious case of this is the sovereign debt issues carried on the balance sheets of many European banks.  The values that many of these banks have on their balance sheets for these assets have the credibility that the recent “stress tests” administered to more than 90 banks by European banking authorities. (Note that the European Union moved today to recapitalize 16 banks,    

But, the problem is not limited to Europe.  How many assets on the books of American banks have values that need to be written down to more realistic market values.  For example, small- and medium-sized commercial banks in the United States have a large portion of their loan portfolios in commercial real estate loans.  The commercial real estate market is still experiencing a depression and market values continue to decline in many areas.  The write off of these loans can take large chunks out of the capital these banks are still reporting. 

The bottom line here is that commercial banks that still have problems are not willing to take on any more risk than they have to while they still have to “work out” these depreciated assets, or, at least, wait until the markets recover and asset values rise once again to former levels.  If you don’t make another loan…it will not go bad on you…so why take the risk of making a new loan.

And there are 865 commercial banks on the FDIC’s list of problem banks and many more surrounding that total that have not met the specific criteria of the FDIC to be considered a problem bank. 

The second reason why many banks shouldn’t be lending right now it that the net interest margin they can earn on loans is hardly sufficient to cover expense costs.  I have talked with many bankers now that say the only way to make any money through bank operations is to charge for transactions.  That is, to generate fee income. 

A general figure that represents the expense ratio of a bank is by taking expenses and dividing them by total assets.  Recent data indicate that this expense ratio is in excess of 3 percent, being around 3.15 percent to be more exact.  This means that on basic lending operations a commercial bank must earn a net interest margin of 3.15 percent in order to “break even”. 

Is there a problem here?  You betcha’!

Adding to this dilemma is the fact that the Federal Reserve has added on a new “operation twist” to the mix.  All these banks need is a flatter yield curve. (See my post 

There are two ways to respond to a flatter yield curve.  First, one can take on more risk in their lending. (See Or, commercial banks can attempt to earn more money through additional fees, or principal investments (private equity or venture capital), or through the assumption of systematic risk taking. (See 

Is this what the Fed wants?  The Fed seems to be caught in the bind that it must be seen as doing something, even though that something may not be very productive (QE2) or even counter productive (leading to bubbles and other speculative activity). 

The take on Fed behavior during the Great Depression has been that the central bank did not do enough.  Hence, Mr. Bernanke and crew are taking the position that history will not brand them with the same interpretation.  For the past three years they have operated so as to avoid the claim that they did not do everything in their power to counteract the forces causing a great recession, slow economic growth, or economic stagnation.

And, here they face the possibility of “unintended consequences”.  If the flattening of the yield curve results in even less bank lending than would have occurred otherwise, the Fed could actually be exacerbating the situation.  The stock market declined upon hearing the Fed’s policy.

The third reason why banks may not be lending now is the absence of loan demand.  Fifty years of government created credit inflation has resulted in excessive debt loads being carried by individuals, families, businesses, governments (at all levels) and not-for-profit institutions.  People, faced with under-employment, declining asset values, and income/wealth inequities, are attempting to de-leverage.  This de-leveraging will continue until people feel more comfortable with their debt loads, or, the Fed creates sufficient inflation so that people will start to take on more debt again. 

If the Fed achieves the latter, then we have returned to the credit inflation situation that has existed for the past fifty years.  This period of credit inflation has resulted in an 85 percent decline in the purchasing power of the dollar, more and more under-employment of labor, and greater income/wealth discrepancies within the society. 

The fourth reason is the uncertainty created in “the rules of the game.”  The Dodd-Frank financial reform act has created a great deal of uncertainty within the financial community.  For one, only about 25 percent of the regulations have actually been written and only a portion of these have passed.  As a consequence, commercial banks don’t know what rules they will have to follow…or, even more important, what rules they will have to find ways to circumvent.  Another new set of rules, these on taxation, were introduced by President Obama this week.  George Shultz, former Secretary of the Treasury, has argued that new, complex tax proposals not only lead to short-term uncertainty about what must be dealt with, but that over time “the wealthy and GE” will find ways to manipulate the tax laws in their favor. (See my posts of September 20 and 22:  But, unfortunately, people, families and businesses, will devote time and resources to dealing with these “rules of the game” and not allocate this time and resources to more productive activities.

Again, I raise the question “Why should banks be lending?”, not the question “Why  aren’t banks lending?”   

Thursday, September 22, 2011

Something is Missing...

The Dow-Jones Stock Index dropped almost 400 points today. European stocks also dropped substantially…the FTSE 100 dropped by over 4 and one-half percent. 

European sovereign debt continues to grab headlines a the interest spreads on ten year bonds of troubled countries versus the yield on ten year German bonds remained near peaks. 

Today, the Economic Union moved to speed up the recapitalization of banks that did not show well in the recent stress tests administered to more than 90 banks.  The move would affect mostly mid-tier banks. Seven are Spanish, two are from Germany, Greece and Portugal, and one each from Italy, Cyprus and Slovenia.” (  But, there is little confidence that this move will resolve things because the stress tests were such a joke!

Moody’s downgraded Bank of America, Wells Fargo, and Citigroup…and a couple of days ago a few European banks…that passed the stress tests. 

And, the top officials in the European Union continue to argue over this issue and they continue to argue over that issue and resolve little…but still hope to kick the can down the street a little further.  No one seems to be facing the real issues because their solutions appear to be so painful.   

In the United States, Ben Bernanke and the Federal Reserve attempt to grasp another straw in the wind as they continue to throw “stuff” against the wall, hoping that some of it sticks.  For three years now the Fed has thrown “stuff” against the wall but it must be too wet…for very little is sticking to the wall.  The Fed’s current monetary policy is to make sure that they throw all the “stuff” they have against the wall so that no one writing future history books can accuse them of not leaving any unused “stuff’ in the …

And, President Obama has come up with his new economic re-election platform disguised in the form of a jobs program, which includes new proposals to finance the program with various tax increases.  Since this combination is a part of the re-election campaign it must contain a little of this and a little of that to appeal to different parts of his voter base.  The problem with something like this is that it just makes the tax code more complex and provides incentives for the more heavily taxed…in the words of George Shultz, the former Secretary of the Treasury, ”the wealthy and General Electric” find ways to avoid bearing the burden of the tax. (See my post from Tuesday, September 20, “The Case Against the Obama Taxes”,   

Something is missing!

My answer has been and continues to be, that the something that is missing is leadership!

The problem is that there are no easy answers…no painless answers. 

People in Europe and the United States have been living high for fifty years.  The goals of high levels of employment and income re-distribution through the spread of home ownership have produced their consequences…excessive amounts of debt in households, businesses, national, state, and local governments. 

The economic policy of almost consistent application of credit inflation for the past fifty years has produced, in the United States, an 85 percent reduction in the purchasing power of the dollar, an under-employment rate of at least 20 percent, and the widest skewing of the income/wealth distribution in recent history.  If this is what credit inflation achieves…I don’t want it. 

Continuing to apply the policies of the past fifty years to the current situation will only exacerbate things.  We are facing an extended period of economic stagnation, at best, and a double-dip recession, at the worst.  Little or no growth in this situation will be accompanied with continued increases in the under-employment rate.  And, of course, continuing with all this stimulation with little of no economic growth will result in even more decline in the purchasing power of the dollar.

And,  as a consequence of the uncertainty related to the attempt to solve these problems, volatility continues to plague the financial markets.  Experts predict that the volatility of these markets will not subside until things settle down on the policy side and some true leadership is shown amongst our governmental officials and regulators.  That is, the volatility will continue until someone steps up to the plate and initiates a real solution to the existing situation.

The problem is that the main job of politicians is to get re-elected.  It is very clear to most politicians that resolving the debt-situation is going to be painful and many are already hearing the discontent of their constituents.  Riots in the streets of Greece and Spain are just a small indication of the disruptions that the politicians fear.  But, there is the fear that if they do too much they will not get re-elected.  The are caught in the trap of having to do something…but not too much.   

The financial markets…the economy…are getting no clear vision of what the future may look like.  They don’t know what their taxes are going to be.  They don’t know what the rate of inflation will be. 

All the financial markets…and the economy…can do is go up…and go down…

Something is missing and the problem with this is that no one in the financial markets…or the economy…can identify where the leadership is going to come from. 

Can you?

Tuesday, September 20, 2011

The Case Against the Obama Taxes

Yesterday, President Obama proposed a tax plan.  George Shultz has replied: “rich people and large companies like General Electric Co. are the beneficiaries of a complicated tax system.”

“It’s wealthy people and the GEs of the world that know how to manipulate these preferences and get their tax rates down,” said George Shultz, an economist and former dean of the University of Chicago’s business school. “The average Joe doesn’t have access to those lawyers.”

George Shultz, also former United States Secretary of the Treasury and Secretary of State, made this statement in an interview with Bloomberg press when arguing for a complete change in the tax code to reflect the realities of the 2010s. (

One could also say the same thing when referring to the ability of “wealthy people and the GEs of the world” to handle the inflationary environment created by governments that are aiming to sustain “high levels of employment” as designated by the full employment objectives of the United States and many other western nations. 

The wealthy and the large corporations can protect themselves or even benefit from inflation.  The “average Joe” cannot do this.  In fact, the “average Joe” ultimately “gets screwed” from inflationary policies aimed at keeping him employed.  Having under-employment rates in the 20 percent plus range is not what was planned as policies of credit inflation dominated the past 50 years. 

Furthermore, credit inflation creates a wonderful stage for financial innovation, shifting jobs from manufacturing and production to financial services and other support industries…like the legal profession.  We can only look at the shift in jobs in the United States over the past fifty years to see the consequences of this development.

The financial innovation of the last fifty years points to another change in the world that not only allowed the financial innovation to take place but provides insight into the world of the future.  The change I am writing about is the advent of the Age of Information.  Financial innovation thrived upon the new technology and the new technology was underwritten by the growth of the financial innovation. 

“Wealthy people and the GEs of the world” (along with the JPMorgan’s, Goldman-Sachs, and others) are able to use this technology “to manipulate” things so as to benefit themselves as much as possible.  They have the tools.  Why did GE come to earn two-thirds of its profits from its finance wing?  And, the same can be said for General Motors and many other “manufacturing” companies. 

And, people are concerned about the fact that over the past fifty years the income/wealth distribution of the United States became so skewed toward the rich.  The credit inflation and social policies of the past fifty years created the conditions for those that could “manipulate” things and get their tax rates down and profit from the inflationary environment that was created by the politicians. 

The “average Joe”? 

The “average Joe” could do little or nothing.  If he “stayed employed”, kept the job at which he was already working, he fell behind.  The “average Joe” needed to become educated, needed to become more technologically savvy, needed to find the “lawyers” and financial advisors to “manipulate” the system.  But, that was not the way the incentives were aligned!

Unfortunately, the objective of the politician does not mesh with that of “the average Joe.”  The objective of the politician is to get elected and then to get re-elected.  Consequently, laws and regulations aimed at keeping “Joe” fully employed in his current job have been crucial.  Empathy with “Joe” was good politics.  The fact that “Joe” was constantly falling behind was not the issue.

The world has changed.  Yet, we can’t seem to get away from the same election strategies that have been followed over the past fifty years.  In my mind, we are going through a cultural shift that is painful and disturbing.  It is a shift that is going to take place, one way or another, and just pursuing the same goals over and over will only exacerbate the pain and the disturbance over time.  And, the constant advancements of information technology will just add to this.  

Shultz is arguing that the “Tax Reform Act of 1986” needs to be revised and reformed, not extended and made more complex.  He argues that “a simplification of the code would allow Congress to lower rates on a ‘revenue-neutral’ basis, while economic expansion would boost tax receipts.

“You’ll get a gusher,” Shultz said. “If you get this kind of stimulative tax policy and other things into effect, there will be a response and revenue will come in.”

 It seems as if “wealthy people and the GEs of the world” will play ball with you when they feel that they are not being singled out and picked on.  Otherwise, out will come the lawyers and the financial advisors and we get results similar to the ones described above.  The problem is that in proposing these changes in the tax codes as Obama has done or creating an environment of inflation, things just don’t stay the same. 

The politician is subject to the same fallacy that is faced by the economist conducting his deductive reasoning.  It is the problem of “ceteris paribus”, the assumption that “all else stays the same.”   When you change the tax code or the inflationary environment, all else does not remain the same.  As a result, you often find yourself facing the problem of “unintended consequences.”  You get results that you didn’t intend to get.  In the case of the economic policy over the past fifty years, you get higher levels of employment and under-employment than you wanted and greater inequality in the distribution of income/wealth. 

The current Obama tax plan is a journey into the past.

Monday, September 19, 2011

The Smaller Banks Continue to Lose Ground

First, we need to define what the Federal Reserve calls “Small” banks.  The Federal Reserve defines small banks as domestically chartered banks that are not counted among the largest 25 domestically chartered banks in the United States.  Hence, “Large” domestically chartered banks are the largest 25 domestically chartered banks in the United States. 
As of September 7, 2011, the largest 25 domestically chartered commercial banks in the United States account for 56 percent of all the banking assets in the United States.  The smaller banks represent about 28 percent.  Foreign related financial institutions control about 16 percent.    
From August 2010 to August 2011, the total assets held by the small banks in the United States grew by one-half the rate at which the total assets in the largest 25 banks.  The “large” banks grew at a 1.4 percent annual rate while the “small” banks grew by 0.7 percent.
Over the last calendar quarter from the banking week ending June 1 through the banking week ending September 7, the smaller banks actually shrank by almost $20 billion while the larger banks grew by about $165 billion. 
Over this last quarter, “Loans and Leases” at the smaller institutions dropped by almost $70 billion.  At the largest 25 banks, “Loans and Leases” rose by over $130 billion.  At the smaller banks, loans fell in ALL categories. 
From the banking week ending August 3 through the banking week ending September 7, “Loans and Leases” at the smaller banks rose by only $1.5 billion while they rose by more than $30 billion at the 25 largest banks. 
One could say that lending activity is increasing on Wall Street but not on Mail Street.   One could ask questions, however, about the type of loans that the larger banks are initiating.  See my posts from last week: and   
But, business loans are not suffering the most at the smaller banks.  Over the past year, residential real estate loans (home mortgages) at these smaller banks have declined by more than 6 percent, year-over-year.  Over the past quarter these loans have fallen by $12 billion. 
And the smaller banks still are suffering through the commercial real estate decline as these loans declined by almost 7 percent, year-over-year through August.  Commercial real estate loans at these banks declined by more than $40 billion over the last quarter alone. 
The FDIC reports that there were 6,413 commercial banks in the banking system as of June 30, 2011.  Of this number, 865 banks were included on the FDIC’s list of problem banks for this date, more than 13 percent of the banks in insured at that time.  Troubled banks total even more than this, some estimate that more than twice this number are very fragile institutions. 
From these data one can argue that bank lending activity may be picking up, but it is not picking up among many of the smaller banking institutions that still face serious balance sheet troubles.  These organizations are not going to participate in any economic recovery and, in fact, are going to have to be closed or absorbed into the banking system that will remain.  As mentioned above, even though loans may be picking up in the largest 25 banks in the country, the loans may not be going into the physical investment that would cause the economy to grow faster than it is. 
Dollar deposits continue to flow out of the United States into foreign banking offices through domestically located foreign related institutions.  From August 2010 through August 2011, cash assets at these domestically located foreign related institutions rose by about $470 billion!  This increase in cash assets tracks closely the Federal Reserve’s implementation of QE2 and represents about 75 percent of the roughly $630 billion rise in cash assets of the whole United States banking system. 
The interesting thing for our purposes is that the item on the other side of the balance sheet that most closely tracks this increase in the cash assets of foreign related banking institutions is “Net Due to Foreign Offices.”  That is, this money is going off shore. 
From August 2010 through August 2011, this account, “Net Due to Foreign Offices”, rose by almost $540 billion.  In the last quarter it rose by over $160 billion.  In the last month it rose by $112 billion. 
Can the rise in this this account be associated with the sovereign debt crisis in Europe and the recent problems faced by many of the large European banks?
I believe one can make a pretty strong case for this conclusion.  The Fed’s QE2 preceded the agreements that the central banks made last week to provide more US dollars to European banks. 
Of course, this provision of US dollars to the world is not spurring on economic growth although it may be helpful to preventing another Lehman Brothers meltdown.  

Thursday, September 15, 2011

Some Banks Are Stretching For Risk

According to Matt Wirz in his article “Banks Apply Lever to Cash Positions” in the Wall Street Journal, this morning ( some commercial banks, generally the larger ones, are stretching for higher yields by taking on more risk.

I have recently discussed this problem in several posts (, and and how it is related to the current policy of the Federal Reserve to keep interest rates at such low levels for the next two years.  Basically, commercial banks cannot earn the interest spreads they need with the term structure of interest rates being so flat.  And, any effort to achieve an even flatter yield curve through an “interest rate twist” policy will just exacerbate the situation.

With the term structure so flat, what is a bank to do? 

Rely on fees?

For an answer to this question see my recent post ( Given the recent volatility in financial markets, larger banks are experiencing substantial shortfalls in trading and investment banking activity which is resulting in much lower fee income than in the past year or two.   New regulations are also resulting in lower fee income.

So with other sources of income shrinking, some banks are turning to higher risk loans in order to gain higher returns to “goose up” earnings.

According to Wirz, “Much of the lending is taking the form of so-called leveraged loans.  They are floating-rate loans made to companies with ‘junk’ or non-investment grade credit ratings, and typically used to finance buyout deals or refinance existing debt.”

In August, for example, leveraged loans totaled $36 billion, a small monthly amount for this year, yet the junk bond market and the IPO market only produced $2 billion combined. 

Wirz states, “there are signs that the risk in this line of lending is rising.  The large leveraged buyouts that banks arranged in the first seven months of the year carried 14 percent more leverage than those underwritten in the same period of 2010…That puts leverage on current deals on par with those financed in 2006, but below 2007 levels.”

Another type of risky loan, called pro-rata loans, is made to “stronger companies with junk ratings—typically rated BB—to boost interest earned…” This type of loan, through July of this year, is already up 16 percent from all of 2010.

Do we have here a case of the “law of unintended consequences”?  The Federal Reserve, in its fear that it will not do enough to prevent a double-dip recession, may be creating an environment that will result in outcomes that, over the longer-haul, may not be what it would like.

It is a good thing to get banks lending again and to get the economy expanding.  However, the loans that are being discussed in the above-mentioned article are not going to economy expanding business investment.  There are plenty of articles elsewhere that indicate there is not a robust amount of demand for loans on the part of businesses, especially those that deal with small- and medium-sized banks.  And, many small- and medium-sized banks are not that anxious to make more “new” loans, given the state of their balance sheets. 

Do we want banks to be making risk-stretching loans for the purpose of financing buy-out deals or refinancing existing debt?  

Historically, we see that this is not the way that the economy usually achieves more rapid economic growth.  Historically, additional risk taking is connected with periods of credit inflation.  Much of what the Federal Reserve has done in recent years, especially the execution of QE2, can be classified under the title of credit inflation. 

And, credit inflation is what we have experienced for the past fifty years!

The consequences of this credit inflation?

Higher rates of under-employment, unused manufacturing capacity, greater income inequality, a busted housing system, and sagging morale. 

Credit inflation does not result in improving productivity but instead results in speculation and bubbles.  As we have gone through the past fifty years, this is exactly what we have gotten…slower economic growth…and more financial innovation and risk exposure. 

Seeing commercial banks beginning to stretch for risk at this stage of the economic recovery is, to say the least, a little disconcerting. 

Wednesday, September 14, 2011

Bankers Expect Weak Profit Performance in the Future

The big bankers are projecting more bad news for their third quarter performance.  A discussion of this can be found in the New York Times article “Banks Brace for a Season of Fall-Offs” (
In what is taken as a reflection of the industry, JPMorgan Chase “warned that third-quarter trading revenue was likely to fall about 8 percent from a year ago.  Investment banking income is also expected to drop by one-third from a year earlier.” 
Note two things about this information.  First, the trading revenue does not come from the trading done by the banks, but from trading transactions initiated by the banks’ clients.  Second, the investment banking income relates to the fees earned on acquisitions and stock and debt offerings. 
As the economy recovered from the financial collapse, these sources of income provided an uplift for the troubled banking industry.  But, as we have seen, the revenues from these sources can show substantial swings from quarter-to-quarter due to the volatility of financial markets.  Now, activity is down and, according to Jes Staley, the head of JPMorgan’s investment bank, income from these sources could continue to be down in future quarters.
No mention here of basic commercial banking.  In fact, one has to go back a substantial amount of time in order to find anything about banking on Main Street.
Oh yes, there has been the noise about how the regulators are hurting or going to hurt bank performance by clamping down on debit card swipe fees and overdraft charges and credit card fees, but there is little or nothing on basic banking activity, like the financial intermediation that connects depositors to borrowers. 
Banking has become a business of collecting fees, whether on trading activity or stock and bond offerings or on business transactions connected with private equity and other types of principal investments. 
The good old business of banking, what Leo Tilman calls “Balance Sheet Arbitrage”, is not doing so well these days and has been declining in importance for years. (See Leo Tilman book, “Financial Darwinism” and my review of it As financial market efficiency has improved through increases in competition and advances in the Internet and information technology, more and more bank customers have achieved greater access to more and more sources of to serve their needs.  As a consequence, there has been a secular decline in the net interest margin banks can earn.
During this decline, in order to earn an acceptable return on “Balance Sheet Arbitrage” banks have taken on riskier loans, mismatched maturities, collected more and more fees, and used greater amounts of financial leverage. ( Adding risk in this way was supported by the credit inflation policies of the federal government for the past 50 years.  However, this bubble has burst…at least, for the time being. 
The pressure on bank net interest margins will continue into the near future if the Federal Reserve keeps interest rates at their current lows for the next two years.  Adding a new “operation twist” to cause long term interest rates to fall further will only exacerbate the interest spreads earned by commercial banks and will perhaps stifle lending even further. (
If these conditions continue, and regulations continue to put downward pressures on many profitable fee sources, banks will be forced to expand further into two other areas that Tilman has defined: Principal Investments (direct private equity and venture capital stakes, investments in hedge funds private equity stakes, or capital allocations to other proprietary investment opportunities) and Systematic Risk Vehicles (taking various risk positions in interest rates, credit, mortgage prepayments, currencies, commodities and equity indies).
I would like to make two comments about these developments.  First, the trends described here are only going to benefit the larger banks.  Most of these activities take trained and experienced individuals that achieve scale economies by being grouped in financially sophisticated organizations. 
Smaller financial organizations cannot afford to hire such expertise and cannot afford to build the departments that will house them.  When the smaller banks have tried to expand their businesses to incorporate these other sources of revenues they generally have gotten in way over their heads and have caused tremendous damage to institutions. 
An example, even from the 1990s: when I was brought in to turn-around a smaller bank during the nineties, I was shocked to find that the investment policy of the bank, approved by the board of directors, allowed the bank’s financial officer to engage in transactions that should only be done in the most sophisticated financial organization.  And, the bank only had one person, not that well trained, to conduct such sophisticated transactions. No wonder it was a troubled bank. 
Smaller banks, with net interest margins continually squeezed, will not be able to generate sufficient earnings to compete with their larger brethren.
Furthermore, banks are going to become less people intensive and will become driven more by information technology.  We are seeing the start of this…Bank of America reducing staff by 30,000 and HSBC laying off 40,000.  Other banks are also downsizing staff.  But, in my view, this is just a start because it is just reducing staff levels that were inflated otherwise.  The future, bank staffs are going to be cut even further as information technology takes over the banking industry.
The future?  Look two places: the first is the direction of banking in many emerging countries; and second, look at what your kids and grandchildren are doing.  Finance is just information.  For one, we don’t need massive branch systems to exchange information.   My children go into a branch, maybe once or twice a year…at most…and this reluctantly.  Their kids?  Don’t bet on them using physical banking facilities…anywhere.  And, look at the emerging nations with poor, spread out populations that historically have been under-banked.  It is truly remarkable the inroads that electronic banking is making in these areas.
I also believe that this second trend will be captured by the larger banks who again can scale up their efforts, both in terms of size of operation and in terms of technical sophistication, far better than can the smaller banks in the country. 
Basic banking, what Tilman calls “Balance Sheet Arbitrage” will continue to exist but in new forms and with changed margins.  But, the remaining banks will have to rely more and more on “Principal Investments” and “Systematic Risk Vehicles” and fees to generate adequate returns.  Putting a “ringfence” around the “Balance Sheet Arbitrage” activities to protect them, as the British have suggested doing, will not change the direction that banking is going. 
The question is “Do Bankers Get It?”