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,” (http://www.nytimes.com/2011/01/09/business/09gret.html?_r=1&ref=fairgame). 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,” (http://www.ft.com/cms/s/0/2388dd24-1c27-11e0-9b56-00144feab49a.html#axzz1AjUYZy6X). 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 (http://professional.wsj.com/article/SB10001424052748704458204576074214100579944.html?mod=ITP_marketplace_0&mg=reno-wsj). 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,” (http://www.nytimes.com/2011/01/08/business/global/08euro.html?scp=1&sq=the%20crisis%20that%20isn'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,” (http://www.ft.com/cms/s/0/c25cc3e6-1cec-11e0-8c86-00144feab49a.html#axzz1AjUYZy6X).

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,” (http://www.ft.com/cms/s/0/c25cc3e6-1cec-11e0-8c86-00144feab49a.html#axzz1AjUYZy6X). 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.

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

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

Sebastian Mallaby, a senior fellow at the Council on Foreign Relations and the author of the book “More Money than God”, writes in the Financial Times” (http://www.ft.com/cms/s/0/9f5584f2-fe1d-11df-853b-00144feab49a.html#axzz173T61Eok):

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

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

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

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

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

Why did this happen?

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

The first reason meant that the government had to keep stimulating the economy to keep people employed in the jobs they had. As a consequence, many American workers did not have the incentive to grow and prepare themselves for the “jobs of the future.” As a consequence, about one out of every four Americans of employment age is “under-employed”! Furthermore, the length of being unemployed has trended upwards from the 1950s and in October 2010 the average duration of unemployment is just about 34 weeks, almost three years. (See “Unemployed and Likely to Stay That Way,” http://www.nytimes.com/2010/12/03/business/economy/03unemployed.html?ref=todayspaper.)

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

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

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

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

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

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

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

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

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

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

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

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

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

Are There Bubbles All Around?

One thing we learned in the 1990s and the 2000s is that there can be asset bubbles in the economy without growth in either money stock variables or increases in consumer (flow expenditure) price inflation. The financial system seems to be flexible enough so that it can leverage up where it wants to even though monetary policy and consumer spending seem to be “in control”. This is the lesson of modern “financial engineering.”

However, the monetary statistics are not benign for most of the time period from January 1961 up to September 2008. During this time period, the monetary base which is supposedly under the control of the Federal Reserve System rose at a compound annual rate of slightly more than 6%. Total credit during this time period rose much more rapidly. Consequently, the United States experienced a period if “credit inflation” that dominated everything going on during this 47 years or so. This secular inflation drove the financial innovation that took place as the whole financial system took on more-and-more leverage and more-and-more risk.

Since September 2008, the Federal Reserve has caused the Monetary Base to increase explosively by more than 130%. However, the banking system is not lending and much of these funds seem to have ended up on the balance sheets of the banking system. Excess reserves in the banking system went from about $2 billion in August 2008 to almost $1.2 trillion in February 2010. Excess reserves for September 2010 averaged slightly below $1 trillion.

Even with all of these excess reserves, the current concern is whether or not the economy will go into a period where prices actually decline. That is, might the United States be headed for a period of deflation?

Everything mentioned above is true. Yet, there is more going on in the economy than just what we see here. In some areas, a lot is going on and in these areas we are seeing lots of upward price movement which leads one to ask whether or not these price movements are bubbles or indications of something else taking place. Certainly, the “bubbles” are not increasing employment, or capacity utilization, or getting the economy going again.

I have written about this before: “Where the Action is: The Bond Market”, http://seekingalpha.com/article/230048-where-the-action-is-the-bond-market. I wrote in this post:

“There is a lot of money in the financial markets…in the shadow banking system…and worldwide.
Where is the action taking place?
Well, for one, in the bond market. We have major companies issuing bonds at ridiculously low interest rates.”

Of course we know that government bond prices are inordinately high causing yields to be excessively low. But, this is also true in the market for high-grade corporate debt and for junk bonds. One could certainly argue that there might be “asset bubble” in the bond markets.

Thank you shadow banking system!

And, the cash continues to build up on the balance sheets of “healthy” large corporations. It also appears as if many hedge funds and private equity funds are attracting “large bunches” of new money.

But, capital is almost perfectly mobile in the modern world: it can escape almost everywhere.

Because of this, writers like Martin Wolf have argued that one of the goals of American leadership is to “inflate the world” in order to get United States economic growth going again.

So, are we seeing the results of this?

Well, we might be seeing this flow of capital going into world commodity markets and also into emerging markets. There is the possibility that bubbles may be occurring here.
The movement in commodities seems to be worldwide but repercussions are being felt domestically in the United States. (See “Dilemma Over Pricing: From Cereal to Helicopters, Commodity Costs Exert Pressure”, http://professional.wsj.com/article/SB10001424052702304741404575564400940917746.html?mod=ITP_marketplace_0&mg=reno-wsj.) This article indicates that, year-over-year, corn prices are up by 34%, wheat prices are up 34%, milk is up 32%, copper is up 30%, and oil is up 14%. It is also the case that sugar is up about 50% year-over-year.

The question many companies are facing is, “How can we raise prices to cover these costs when the economy is so weak?” A real dilemma!

Funds are also flowing into emerging markets. All one has to do is watch the stock exchanges in those countries. And, all indications are that large companies are looking to locate in many of these markets or acquire firms in these markets. We are also seeing the hedge funds and private equity funds looking in this direction. (See for example, “Buy-outs set to divide private equity”, http://www.ft.com/cms/s/0/726ce11e-dc6d-11df-a0b9-00144feabdc0.html.)

In a world where there is a fluid movement of capital, money is not going to stay at home if the home economy is not strong, structurally. The American economy is having major problems in its economy. Why would “big” money want to invest here? (See, for example, “Globalized Finance: Advantage China”, http://seekingalpha.com/article/229600-globalized-finance-advantage-china.)

The Federal Reserve, and the federal government, may need to change their economic models to include the fact that organizations other than domestically chartered commercial banks can create credit and can cause bubbles to occur anywhere in the world where an opportunity exists.

Modern finance with internationally mobile capital does not seem to exist in the models the leaders of the United States are using. This is one reason for my skepticism of all the new financial reform systems that are being constructed. (See my post “Banking at the Speed of Light”, http://seekingalpha.com/article/208513-banking-at-the-speed-of-light.) Money is becoming more and more fluid and hence less and less controllable.

The American banking system may currently be dormant, but there seems to be plenty of money and plenty of action, elsewhere.

Yes, there are bubbles all around.

"Currency Chaos: Where Do We Go From Here?"

I would strongly recommend you read the “Weekend Interview” published in the Wall Street Journal on Saturday. The interview is with Robert Mundell, 1999 Nobel prize-winning economist who teaches at Columbia University. Mundell has been referred to as the “father of the euro.” (http://online.wsj.com/article/SB10001424052748704361504575552481963474898.html?mod=WSJ_Opinion_LEADTop)

Let me just summarize some of the points Mundell makes in the interview because, I believe, that more people should be aware of them.

First, Mundell reflects a bit on history and states that the major event of the post-World War II period was the United States going off the gold standard in 1971 and letting the value of the dollar float. “The price of gold was fixed at $35 an ounce in 1934, but by the time the U. S. got through the Korean War, the Vietnam war, with all the associated secular inflation, the price level had gone up nearly three times.” The U. S. lost more than half its gold stock and had to get off the gold standard.

No one has suggested any system, gold or whatever, to stabilize prices since. And, the “secular inflation” has continued into the 21st century.

Second, the dominance of the United States and the dollar in the world economy, which began in the 1930s, has declined. “”To be fair, America’s position (in the international community) is not nearly as strong now.” But, Mundell doesn’t “think the U. S. has any ideas, they don’t have strong leadership on the international side. There hasn’t been anyone in the administration for a long time who really knows much about the international monetary system.”

Third, it is wrong to think that the world situation revolves around the United States versus China faceoff. “It’s a multilateral issue because the U. S. deficit is a multilateral issue that is connected with the international role of the dollar.” Mundell supports the suggestion of French President Nicolas Sarkozy that discussions should begin on reforming the world monetary system. But, he argues that the Europeans must play a very important part in any discussions because the dollar-euro relationship is so important in world financial markets. “The dollar and the euro together represent about 40% of the world economy.”

Fourth, the world currency system needs to be based on fixed exchange rates and not flexible ones. Mundell believes that almost all of the volatility in foreign exchange markets is “noise, unnecessary uncertainty.” World trade will be better off without having to deal with this “noise” because “it just confuses the ability to evaluate market prices.”

The argument against fixed exchange rates is that, in a world where capital flows freely between nations, a country cannot run an independent economic policy aimed at achieving things like full employment and price stability and still maintain a stable exchange rate. This argument is called “the Trilemma problem” of international economics: you can only achieve two of these goals; capital mobility; fixed exchange rates; and an independent governmental economic policy. (For more on this see my post, http://seekingalpha.com/article/227990-monetary-warfare-can-nations-have-independent-economic-policies.)

What about a country losing the ability to run an independent economic policy?

Mundell is asked the following question: “I suppose the Fed officials would argue that their mandate is to try to achieve stable prices and maximum levels of employments.”

The answer: “Well, it’s stupid. It’s just stupid.”

“The Fed is making a big mistake by ignoring movements in the price of the dollar, movements in the price of gold, in favor of inflation-targeting, which is a bad idea. The Fed has always had the wrong view about the dollar exchange rate; they think the exchange rate doesn’t matter. They don’t say that publically, but that is their view.”

Hence, the fifth point is that monetary and fiscal policy should not be conducted independently of what is going on in the rest of the world. A country, even the United States, cannot continue to inflate its currency without repercussions. The government cannot continuously ignore what is happening to the value of its currency. If a country does ignore what is happening to its exchange rate there will be consequences to pay down the road.

Sixth, “the price of gold is an index of inflationary expectations.” What is it reflecting? Mundell argues that a rise in the price of gold might indicate “that people see huge amounts of debt being accumulated and they expect more money to be pumped out.”

“Look what happened a couple weeks ago: The Fed started to say, we’ve got to print more money, inflate the economy a little bit. The dollar plummeted! (The price of gold rose!) You won’t get a change in the inflation index for months.” But, the decline in the exchange rate and the rise in the price of gold is a “first signal.”

Read the article.

Coming Crunch for Smaller Banks?

Two months ago I was hoping I was seeing some “Green Shoots in Smaller Bank Lending,” (http://seekingalpha.com/article/220685-green-shoots-in-smaller-bank-lending). Last month I found very little encouragement in the banking data released by the Federal Reserve: “Still No Life in Banking,” (http://seekingalpha.com/article/224851-still-no-life-in-banking).

The most recent data seem to indicate that things may be getting worse.

Remember, as of June 30, 2010, the FDIC listed 829 banks on its list of problem banks, and these banks are the smaller ones. Note that this is more than ten percent of the commercial banks in the banking system. Elizabeth Warren, in congressional testimony, has stated that there are at least 3,000 commercial banks facing major problems in the future, primarily in the area of commercial loans, (http://seekingalpha.com/article/215958-elizabeth-warren-on-the-troubled-smaller-banks.) I have made my own forecast that the number of domestically chartered banks in the United State will drop from around 8,000 to less than 4,000 in the next five years or so (http://seekingalpha.com/article/223340-say-goodbye-to-the-smaller-banks).

Total assets in the smaller banks in the United States (the smaller domestically chartered commercial banks consists of all banks below the top 25 in asset size and make up about one-third of the banking assets in the United States) are about the same this year as they were last year. Yet, cash assets in these banks increased by almost 38% from August 2009 to August 2010 and by more than 2% in the four week period ending September 29, 2010.

The concern, of course, is that the smaller banks are preparing for more trouble in the future. The larger banks are now in the process of reducing their cash assets: the cash asset at large, domestically chartered banks are down about 4% over the last four weeks; down about 5% over the past thirteen weeks; and down about 6% over the past year.

Thus, the decline in excess reserves that has occurred in the banking system over the last six- to eight-week period, has come in the big banks indicating that they are prepared to adjust to a new lower level of liquidity in the banking system.

However, the smaller banks are not ready to become less liquid, just the opposite. This, to me, indicates that the Federal Reserve is staying “extremely loose” not so much because the economy is weak, but because the solvency of the smaller banks in the banking system is in question.

There is no doubt that the smaller commercial banks in the United States are getting more conservative. Loans and leases at these smaller institutions continue to decline; they have dropped about one percent in the last four weeks.

The thing to keep an eye on, however, is the commercial real estate portfolio. In the smaller domestically chartered banks, the decline in these loans on the bank balance sheets seem to have accelerated in the past four weeks and in the past thirteen weeks from earlier time periods.

Commercial real estate loans have declined across the board, but the concern is that commercial real estate loans make up about 26% of the assets of the smaller domestically chartered banks and only are about 8% of the assets of the large banks. The declines in the smaller banks have a proportionately larger impact than does a similar decline in the big banks. Furthermore, this is where Elizabeth Warren pointed us to in her congressional testimony.

The two categories of loans that have recently increased at the smaller banks are “Revolving home equity loans” and “Credit card and other revolving plans.” The home equity loans at these smaller banks have risen by about 2% over the past 13-week period and are up slightly over the past 4-week period. At the big banks these loans are down by over one percent for the longer period and down slightly less than one percent for the shorter period.

Credit card and other revolving debt at the smaller institutions is up by over 4% in the past 13-week period and up by about 3% in the past 4-week period. At the larger banks, these numbers are down 3.5% for the longer period and down one percent for the shorter period.

Recent analysis of credit card debt indicates that, for the larger issuers, much of the decline in credit card debt has come because of these organizations charging off bad debt.

Could it be that the smaller banks are not charging off their delinquent home equity loans and credit card or revolving consumer debt because they don’t have the capital to absorb the losses? Could this be the reason that these loans are increasing at the smaller banks and not at the larger banks?

If one accepts this analysis, then the smaller banks have a lot to do on their balance sheets in the future to handle not only troubled commercial real estate loans but to handle revolving credit debt. Do the smaller commercial banks have the capital to go through this process?

There remain many concerns about the commercial banking system. Now that people expect that we will go through a period in which the profit performance of the larger banks is to be relatively flat, might this put even more pressure on the overall United States financial system?

My guess is that the big banks will do just fine. The problem is with the smaller banks, and the situation does not look encouraging for them. I still believe that this is the main reason why the Federal Reserve is keeping excess reserves in the banking system at such a high level. The Federal Reserve, in my mind, is scarred silly that there still may be massive bank failures in the future. The FDIC has been smoothly working through bank closures and helping many distressed institutions to find partners to absorb them. The question remains as to whether the massive amounts of liquidity in the banking system will allow this “work out” to continue its smooth and quiet pace in the face of growing problems with commercial real estate debt and consumer revolving debt?

"We don't know what we are doing"--the Fed

The Federal Reserve has two basic problems right now. First, those running the Fed don’t know what they are doing. Second, they are doing a terrible job explaining this to the world.

Never have I seen such confusion in such an important institution. Never have I seen such inadequate leadership.

We have experienced the end of the Fed’s exit strategy, the effort undertaken by the Fed to reduce the size of the Fed’s balance sheet. The exit strategy was designed to reduce the massive amounts of reserves pumped into the financial system by the Fed so that a period of hyper-inflation would not result. That exit strategy saw the Fed’s balance sheet grow by $331 billion over the twelve-month period the “exit” strategy was in place. Excess reserves held by the banking system rose by 38% during the same time period.
(http://seekingalpha.com/article/219717-federal-reserve-exit-watch-part-13)

One can only imagine what the end to the "exit strategy” will mean for bank reserves.

So, the Fed is now not going to let its balance sheet decline. As securities mature it will replace those securities with newly purchased securities. Impact is “net zero” on the balance sheet. If the economic recovery does not pick up steam or if it stalls or even declines, the Fed will purchase even more securities resulting in a further increase in bank reserves.

The reason for this change in focus? Well, the Fed has observed that the economy is moving more slowly than previously thought.

This is the Fed and the Fed leadership that continued to fight inflation as the housing market tanked and financial institutions balanced on the edge of collapse. The Fed seems to have totally missed the August 2007 meltdown of hedge funds failing to act until September 2008. Then, in the fall of 2008, Bernanke panicked and we got the infamous TARP legislation and an inconsistent mish-mash of bailouts that “saved the financial system.” (http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic)

The Fed continues to frame its statements in terms of the weakness of the economy. However, in the statement released after the last meeting of the Open Market Committee the Fed admits that “Bank lending has continued to contract.”

This is all the attention the Fed gives to the banking system; the industry which the Fed supposedly knows intimately? And, this banking system has over $1.0 in excess reserves and is not lending? This banking system that has 775 banks on the FDIC’s list of problem banks? This banking system that Elizabeth Warren claims has 3,000 banks facing severe solvency problems? This banking system that has one out of every 2 banks in it in trouble?

The statements of the Fed just don’t coincide with what people and the financial markets see out in the real world.

There seems to be a significant disconnect between what is going on in the Federal Reserve and what is going on in the world. Damn those econometric models!!!


We got where we are because the Fed didn’t understand what was happening and then threw everything it could against the wall to see what would stick. I fear that we are experiencing déjà vu all over again!

Federal Reserve Exit Watch: Part 5

Something new this week: the Fed started to see how the financial markets would accept its strategy for reducing the size of its security portfolio. At the close of business on Wednesday December 9, 2009 the Federal Reserve showed $180 million on its balance sheet under the line item “Reverse repurchase agreements”.

The Federal Reserve had warned us that it was going to start “testing” the use of reverse repos as the mechanism for reducing the size of its securities portfolio. It had also informed us that a “test period” would begin last week.

It has begun, albeit in a very small amount.

Reserve balances with Federal Reserve Banks changed by only an insignificant amount last week.

Reserve balances did rise over the past 4 weeks and the past 13 weeks. In the last 4-week period reserve balances rose by a little more than $60 billion, $52 billion coming from factors supplying reserves and a negative $10 billion from factors absorbing reserves.

The $52 billion increase in factors supplying reserves was centered on an $85 billion increase in securities held outright ($79 billion in Mortgage-backed securities and $6 billion Federal Agency securities) and a $36 billion reduction in two accounts associated with the insertion of funds into the banking system early in the financial crisis last year. The Term Auction Credit Facility (TAF) dropped by almost $24 billion in the last four weeks and Central Bank Liquidity Swaps fell by about $13 billion.

The rest of the items connected with the innovative market facilities that the Fed created during the time of financial distress changed very little.

So the “Special Facilities” continue to wind down and the Fed continues to substitute marketable securities in its portfolio for the funds that were injected into the banking system to stem the crisis.

In terms of factors absorbing reserves at this time, the general account of the U. S. Treasury Department, its operating account at the Fed (it pays its bills out of this account), dropped by about $8 billion and this added reserves to the banking system and was the primary factor in the additional $10 billion increase in Reserve Balances mentioned above. The Treasury writes checks, they get deposited in banks, and bank reserves increase.

Over the longer term, the last 13 weeks, the government accounts have played a big part in the injection of reserves into the banking system. There is an account titled “U. S. Treasury, Supplemental Financing Account” which has been around since October 2008 (and reached a maximum of about $560 billion in November 2008 (Connected with TARP?). This account declined by $185 billion over the last 13 weeks.

The U. S. Treasury general account rose by $51 billion during this time, apparently the funds from the supplemental account were transferred to the general account so that they could write checks on it. Consequently, the net of the two, $134 billion got into the banking system and ended up as a part of Reserve Balances with Federal Reserve Banks.

During this 13-week period, the Fed also supplied $100 billion in reserves to the banking system through open-market purchases. To do this the Federal Reserve added $281 billion to the securities that it bought outright. The purchases were across the board: $229 billion in Mortgage-backed securities; $33 billion Federal Agency securities; and $19 billion in Treasury securities.)

The run-off in the special accounts over the past 13 weeks is obvious. The Term Auction Credit Facility (TAF) declined by $126 billion and Central Bank Liquidity Swaps fell by $45 billion, a total of $171 billion.

Primary bank loans from the discount window also fell by $10 billion so, over the past 13-week, period the Fed supplied reserves by buying $281 billion in securities and this was offset by a decline in “crisis” accounts of $171 and $10 in bank borrowing so that $100 billion additional funds reached Bank Reserves.

Conclusions:

1. The Federal Reserve continues to let accounts connected with the financial crisis run off. This appears to be going along quite smoothly.
2. The Federal Reserve continues to substitute funds from open-market purchases to replace the funds that are running-off. This appears to be going along quite smoothly.
3. The Fed is now testing the mechanism, Reverse Repurchase Agreements, by which it means to reduce its portfolio of securities and drain excess reserves from the banking system. The first test went along quite smoothly.
4. The U. S. Treasury supplemental financing account is now just $15 billion and will probably not be a big factor in changing bank reserves in the future.
5. The Federal Reserve is going to be facing a lot of “operating factors” over the next month that may cloud up any other actions that the Fed may be taking. These “operating factors” relate to government deposits and the increased use of currency in circulation during the holiday season. These disruptions should end by the middle of January 2010.

Note: Excess Reserves in the banking system still are running above $1.1 trillion. There is little evidence yet that banks want to do anything with these reserves other than hold onto them: this, in spite of the efforts of the Obama administration to get banks lending, especially to small business.

The Secret No One Wants to Tell

The one thing that seems to provide an explanation for a lot of the things going on today is the continued weakness of the banking sector. It explains the actions of the Federal Reserve System. It explains the actions of the Treasury Department. It explains much of the data that are being released. And, it explains much of the behavior of the banking sector, itself.

The secret: the banking sector is a lot weaker than the government is letting on and the government does not want to publically recognize the fact.

The FDIC recently released numbers on the banking industry for the third quarter. Profit-wise, the industry is very skewed. It is skewed toward the larger banks. The results have been summarized this way:

• Banks with assets less than $1 billion in assets roughly broke even in the third quarter;
  
• Banks with assets between $1 billion and $10 billion, on average, lost $3 million apiece;
  
• Banks with assets in excess of $10 billion recorded an average profit of nearly $42 million each.
  

The big banks, the banks that the regulators were most concerned with, are reaping a bonanza. And, why not? The Fed is keeping short term interest rates down: financial institutions can borrow for three-months in the range of 20-25 basis points in the commercial paper market and the large CD market; they can borrow for six-months in the 30-65 basis points in the CD market or the Eurodollar market. They can buy Treasury bonds that can yield 330 to 400 basis points. This is a nice spread. Plus these banks are traders and there has been plenty of volatility in the bond market in recent months. And, this does not even include the possibilities that exist in the carry trade.

As Eddy, Clarke's brother-in-law, remarked in the movie “A Christmas Vacation”: “This is the gift that just keeps on giving!”

Why?

Because the Fed is going to keep short term interest rates low for an “extended period” of time.

This effort is just another way to “bail out” the big banks!

But, what about the banks that are smaller than $10 billion in asset size?

Here the commercial banking industry has been given a gift of $1 trillion in excess reserves.

And, what is going on in this part of the banking industry? The FDIC released the third quarter information on problem banks. The total of problem banks in the country is 552, up from 416 at the end of the second quarter. Almost all of these banks are of the smaller variety. Given that 50 banks were closed in the third quarter this means that 186 new banks achieved the honor of being placed on the problem list in the third quarter.

It is estimated that at least one-third of the 552 “problem” banks, or 182, will fail in the next 12 to 18 months. If this is true then the United States will experience 2.5 to 3.5 bank closures a week for the next year to a year-and-a-half. This is slightly below the rate of 3.8 bank closures per week that was achieved in the third quarter. The hope is that this situation won’t get worse.

The path ahead for even those banks that are not on the problem list is treacherous. Real Estate Econometrics released information that the US default rate for commercial mortgages hit 3.4% in the third quarter of 2009. This is a 16-year high. The company also released projections indicating that this default rate could rise to more than 5% in 2011. Many of the banks in the middle tier possess millions of dollars of these loans on their balance sheet, relatively more so than do the big banks.

The huge debt of Dubai and Greece and others hang over this market.

In terms of residential mortgages, the picture does not improve. First American CoreLogic, a real-estate information company, recently released data that indicated that roughly one out of four borrowers is underwater in terms of their mortgages. Even 11% of the borrowers who took out mortgages in 2009 owe more than their home’s value.

The Treasury continues to push mortgage firms and others for loan relief. There is an indication that some borrowers are not really helped by the relief measures already promoted and that many who have been helped still face the possibility of re-default going forward.

And, layoffs continue in large numbers, foreclosures continue to take place at a high rate, and large numbers of bankruptcies, both personal and business, continue to occur. Another fact, out this morning, is that delinquencies on auto loans are on the rise.

And, banks are not really lending in any form. The Federal Reserve continues to pump funds into the banking system, yet commercial banks seem to be very content to accept the funds and just hold onto them in the most riskless way possible. If you don’t make a loan, it won’t turn bad on you. Furthermore, commercial banks face the situation in which the longer term liabilities they had accumulated earlier in the decade are going to be maturing. They will need money to pay off these liabilities without replacing them.

Charles Goodhart, Senior Economic Consultant at Morgan Stanley, writes in the Financial Times that central banks should declare victory in the war against financial collapse and cease their policy of quantitative easing. (See “Deflating the Bubble”, http://www.ft.com/cms/s/0/2b7b26de-ddcd-11de-b8e2-00144feabdc0.html.) He writes, “If the authorities go on blowing up financial markets too much, at some point yet another bubble will develop. The last time the financial bubble burst, the taxpayers got soaked...Certainly, we can never get the timing exactly right, but now does seem the moment to declare victory for (Quantitative Easing) and withdraw.”

That is, unless there is something we don’t know and the government is not telling us, like the extent of the weaknesses that exist within the banking sector.

Federal Reserve Exit Watch Part 3

This is the third post in a series designed to review the progress of the Federal Reserve in its efforts to exit the position it has created for itself by more than doubling the size of its balance sheet. (The first two posts in this series appeared on August 21 and September 18.) Some fear that if the Fed cannot reduce the size of its balance sheet that the amount of reserves that have been put into the banking system will explode in the creation of new credit which will be followed by an explosion in the various measures of the money stock. This can only be inflationary with substantial concern that such inflation could turn into hyperinflation.

The fear of many others is that the Fed will withdraw these funds too quickly thereby causing the banking industry further problems and the experience of a second financial collapse.

Bottom line: Reserve Balances with Federal Reserve Banks rose by $190 billion in the four weeks ending October 14, 2009. The rise over the last thirteen-week period was $244 billion. These Reserve Balances totaled $1,049 billion on October 14, a new record high! These data are taken from the Federal Reserve Statistical Release H.4.1.

Required reserves in the banking system averaged about $63 billion in the two banking weeks ending October 7. Excess reserves in the banking system, as reported in the Federal Reserve Statistical Release H.3 were $918 billion for the same period of time. Reserve Balances with Federal Reserve Banks were $963 billion on October 7.

Obviously, there are plenty of reserves in the banking system and the banks still do not seem to be in any mood to begin lending again. See my post on the lending activity in the banking system to support this conclusion: http://seekingalpha.com/article/165994-commercial-real-estate-lending-problems-hitting-the-smaller-banks.

Where did this $190 billion of new reserve balances come from?

Well, about $52 billion came from factors supplying reserves to the banking system and another $137 billion came from a reduction in factors that were absorbing reserve funds. For the thirteen week period, factors supplying reserves contributed $121 billion to the $244 billion increase and there was a $123 reduction in factors absorbing reserves. Let’s look at both in turn.

As was highlighted in the previous two reports on the exit strategy of the Fed, the monetary authorities continued to allow accounts associated with the special facilities created to deal with the financial crisis to run off. These reductions were offset by purchases of financial assets. This seems to be the first move strategy of the Fed to achieve its exit from the big buildup.

Over the past four weeks, there was a $61 billion decline in three asset categories connected with the new facilities that were created. The Term Auction Facility (TAF) declined by almost $41 billion, the portfolio holdings of Commercial Paper declined by $3 billion and the line item associated with Central Bank Liquidity Swaps fell by a little more than $17 billion.

Over the last thirteen weeks these three items declined by almost $260 billion: TAF dropped by $118 billion; the commercial paper facility by $71 billion; Central Bank swaps fell by $68 billion.

The Fed replaced these run-offs by open market purchases that more than covered the outflow, hence the overall increase in bank reserves. For example, Securities Held Outright by the Fed jumped $103 billion in the last four weeks and by over $360 billion in the last thirteen weeks.

The Fed is therefore allowing the special facilities to decline where possible and is then maintaining the liquidity of the banking system by purchasing securities in the Open Market!

In purchasing securities in the open market the Fed is buffing up the liquidity in these markets and helping to keep interest rates low. Of particular note, the Fed has added $78 billion in Mortgage-Backed Securities to its portfolio over the last four weeks and $237 billion over the last thirteen. The Fed has purchased Federal Agency Securities in recent weeks: this portfolio has increased by $11 billion and $35 billion in the last four and thirteen weeks, respectively.

Two other items of note: first, something called Other Federal Reserve Assets rose by $6 billion over the last four weeks and by $13 billion over the last thirteen weeks. What is in this account? Well, the Federal Reserve states that this account includes Federal Reserve assets and non-float-related “as-of” adjustments. These may include Assets Denominated in Foreign Currencies or Premiums Paid on Securities Bought. We don’t really have any information on the totals, but these amounts are relatively substantial amounts, especially when the required reserves in the banking system only total $63 billion.

The second item that requires some attention is that the Special Drawing Rights (SDR) account at the Fed increased by $3 billion over the last four weeks. Actually the increase came in the banking weeks ending September 23 and September 30. Thus the Special Drawing Rights certificate account at the Federal Reserve rose from $2.2 billion to $5.2 billion during this period. I am going to have to do more research into this increase and what it means.
In the meantime here is a definition of the SDR: SDRs were originally created to replace Gold and Silver in large international transactions. Being that under a strict (international) gold standard the quantity of gold worldwide is finite, and the economies of all participating IMF members as an aggregate are growing, a purported need arose to increase the supply of the basic unit or standard proportionately. Thus SDRs, or "paper gold", are credits that nations with balance of trade surpluses can 'draw' upon nations with balance of trade deficits. So-called "paper gold" is little more than an accounting transaction within a ledger of accounts, which eliminates the logistical and security problems of shipping gold back and forth across borders to settle national accounts.

The other major contributor to the rise in reserve balances at commercial banks was a movement out of federal government accounts at the Federal Reserve. There was a movement of $157 billion out of government accounts in the last four weeks and $149 billion in the last thirteen. A reduction in these accounts takes place when the government disburses money and the funds end up as bank reserves. In terms of the governments’ general account, the movement of funds, in and out of this account, is usually connected with seasonal tax collections and disbursements.

There is another account that saw a large reduction, $100 billion, over the last four weeks. This was in an account called the U. S. Treasury Supplementary Financing Account. The Fed defines this account in this way: “With the dramatic expansion of the Federal Reserve's liquidity facilities, the Treasury agreed to establish the Supplementary Financing Program with the Federal Reserve. Under the Supplementary Financing Program, the Treasury issues debt and places the proceeds in the Supplementary Financing Account. The effect of the account is to drain balances from the deposits of depository institutions, helping to offset, somewhat, the rapid rise in balances that resulted from the various Federal Reserve liquidity facilities.” Thus, a movement out of the Fed injects deposits into depository institutions.” We need more information on this decline.

To conclude: The Fed continues to reduce dollars associated with the new facilities created to combat the financial crises. It is replacing these dollars with open market purchases that keep the banking system liquid. Other transactions have also taken place related to federal government disbursements that add reserves to the banking system. In restructuring its balance sheet the Fed is being sure to err on the side of being too loose in supplying bank reserves. Obviously, the leadership at the Fed does not feel that any type of constraint should be imposed upon the banking system at this time.

Credit Market Debt: Why Is So Much Going to Bank Holding Companies?

Credit market debt increased by only 3% from the end of the second quarter of 2008 to the end of the quarter of 2009, a total of roughly $1.5 trillion. Of course, the primary story concerns the shifts in borrowing that took place during this time. The data used in this analysis is from the Flow of Funds accounts from the Federal Reserve.

One should note that the only two really substantial increases in credit market debt during this time period were the Federal Government and bank holding companies. Bank holding companies?

The Federal Government is easily identified as one of the primary borrowers during this time period as the debt of the government rose 36% or a total of $1.9 trillion. This is the largest year-over-year increase, dollar-wise, in history! But, this is not a surprise for we knew this was coming.

Note, that this increase does not include other sources of government debt extension in what are called “Funding Corporations” that include the creations of the Federal Reserve System to fund AIG and so on. This source of government funding reached a maximum of $445 billion in the fourth quarter of 2008 and dropped off to only $224 billion by the end of the second quarter of 2009.

One thing that has interested me is the performance of the commercial banking industry. The commercial banking industry, as a whole, has increased its use of credit market debt by a little more than 23%, although U. S. chartered commercial banks have actually reduced its reliance on this source of funds by about 6%. Note, too, that the credit market debt of the whole financial sector declined by about 1%.

The difference has come in the dramatic increase in the use of credit market debt by bank holding companies. Bank holding companies increased their use of this source of funds by 50%, an increase of $365 billion. In the process, the bank holding companies reduced their reliance on commercial paper by $78 billion and raised a net of $443 billion in corporate bonds. Thus there was not only a substantial increase in the funds bank holding companies raised during this time period, there was also a lengthening of the liabilities of these institutions.

One should call attention to the fact that Goldman, Sachs and Morgan Stanley became bank holding companies during this time period. How much of an impact this fact had on these aggregate numbers is hard to tell, but one should be aware of this movement. These two organizations became bank holding companies on September 22, 2008 and the bank holding numbers did not really increase appreciably during the third or fourth quarters of the year. Although total financial assets in bank holding companies rose modestly from the end of the second quarter to the end of the fourth quarter, actual credit market liabilities decreased. The numbers really began to jump upwards at the end of the first quarter of 2009.

Another factor influencing bank holding company debt during this time is the guarantee on bank bonds provided by the federal government. This gave bank holding companies the ability to raise funds relatively more cheaply than they could have raised them otherwise: a good reason to raise funds.

The interesting thing is that the raising of these funds did little or nothing to spur on bank lending or commercial bank growth. Investment in bank subsidiaries by bank holding companies went up by about $112 billion but this certainly doesn’t seem to have gone into bank loans since most of the increase in U. S. chartered commercial bank assets has been in the form of a rise in cash assets and government securities.

Total financial assets at banks rose by about $950 billion from the end of the second quarter of 2008 until the end of the second quarter of 2009. However, cash assets and reserves at the Federal Reserve rose by $430 and Government, Agency and GSE-backed securities rose by $185 billion. The only lending category to show much of a rise was the mortgage category, $233 billion, and this was primarily in commercial real estate. Commercial loans actually declined by about $100 billion. Something called Miscellaneous Assets rose by about $160 billion. Not a lot of lending going on in the banking sector.

However, investment by bank holding companies in nonbank subsidiaries actually rose by about $630 billion and investment in Other Miscellaneous assets rose by about $150 billion!

Thus, bank holding companies invested almost $800 billion in funding nonbank assets.

It seems as if big financial institutions are continuing to behave in the same way that they did before the financial markets started to unravel toward the end of 2007. That is, they put their money into non-bank operations, areas that the regulators did not have a lot of insight into or control over. That is, the banking system is still not relying on the fundamentals of banking to make money these days! They are returning to the areas that proved to be so profitable to them before the crash. And, once again, we seem to be in the dark as to what exactly they are doing.

Even through the credit crisis of 2008 and 2009, the credit markets provided some issuers of debt a substantial amount of funds. However, it seems as if these funds are going into hands that were very similar to the ones that were obtaining funds right before the crisis took place.

Reasons for the slowdown in M2 growth: A Thrift Industry Crisis?

A surprisingly large amount of attention has recently been given to the slowdown in the growth rate of the M2 measure of the money stock. Around the first of the year, the year-over-year rate of growth of the M2 money stock was around 10%, a healthy rate of increase given the recession and the stance of quantitative easing on the part of the Federal Reserve.

Now, the year-over-year rate of growth in the M2 money stock measure has dropped below 8% and concern has been raised about the weakness in this particular indicator of the effectiveness of monetary policy. The question this weakness raises concerns the ability of the Federal Reserve to influence the real economy and the fact that the economy remains very, very weak.

The reason for this weakness, I believe, has less to do with the effectiveness of the Fed’s monetary policy and more to do with the shift in funds within the financial system. For one, the year-over-year rate of increase in the M1 money stock continues to be quite high, averaging more than 18% in the past month or two.

Whereas the M1 money stock increased about $260 billion over the past year, the M2 measure rose by $600 billion. Thus, the increase in the non-M1 part of the M2 measure was approximately $340 billion. The difference in growth rates for the aggregate measure obviously comes because the base for the M2 growth is much larger than the base for the M1 growth.

But, another interesting shift has occurred within these figures. Some deposit levels within the
non-M1 part of the M2 measure have actually declined over the past year. Note where the declines came: they came in time and savings deposits at thrift institutions and in retail money funds.

People are taking their money out of thrift institutions and money funds and putting them into deposits at commercial banks!

Time and savings deposits at thrift institutions fell about $130 billion over the past year and retail money funds dropped by almost $160 billion.

Note that time and savings deposits at commercial banks rose by $625 billion during the same time period.

This movement is reinforced by the shift in “other checkable deposits” over the past year. Other checkable deposits at commercial banks rose by about $50 billion whereas the same type of accounts at thrift institutions remained roughly the same. (Demand deposits at commercial banks increased by about $125 billion over the same time period.)

If one looks at the flow-of-funds accounts, the total financial assets at savings institutions dropped by about $420 billion from the second quarter in 2008 to the second quarter in 2009. Deposits at these institutions dropped by almost $200 billion and credit market instruments (supplying funds to these institutions) fell by about $280 billion.

What we seem to be observing is a massive withdrawal of funds from the thrift sector! This, I would suggest, is not a result of the monetary stance of the Federal Reserve System.

Very little attention has been given to the thrift industry over the past year. Maybe some more attention should be directed to the problems being faced by this industry.

The Deleveraging Continues

There are three major factors that will contribute to the timing and the strength of the economic recovery. First, there is the ability and speed at which individuals and businesses are able to get their balance sheets in order by reducing the amount of debt they have on them. Second, there are supply side questions about the restructuring of the economy. This has to do with the large number of people that have left the labor force and may not return in the near term and the secular decline in the capacity utilization of industry. (See my post of June 22, 2009, “Structural Shift in the U. S. Economy is Really in Supply”: http://seekingalpha.com/article/144508-structural-shift-in-the-u-s-economy-is-really-in-supply.) Third, there is the tremendous amount of debt the federal government is issuing and the fear that this re-leveraging will create a credit inflation that may go right into prices rather than output and employment.

In this post, I am primarily focusing on the first of these factors. I will discuss the progress of the second two issues in future posts. There is more immediate information on the first and it is vitally important that this deleveraging takes place in an orderly fashion or the near term concern over the latter two will be misplaced.

Perhaps the two most highly publicized methods of deleveraging continue to speed along at a rapid pace. The American Bankruptcy Institute has reported that the total number of bankruptcies in the United States filed during the first six months of 2009 increased by 36 percent over the same period of time in 2008. The only time bankruptcies have been so large is right before the bankruptcy law change earlier in this decade. Business filings during the first six months were up 64 percent over the first six months in 2008 and individual or household filings were up 35 percent.

Bank closings reached 81 for the year with four new banks added to the list on Friday, one of them being the 10th largest bank failure in United States history. Talk now is that there will be 300 or more bank closures in the near future. The FDIC is scrambling to find ways to increase its financial resources to handle the upcoming deluge of failures and is also easing restrictions on those that can bring private equity into the mix to carry some of the financial burden in taking over these failed institutions.

Getting less publicity is the effort that individuals and businesses are making to bring their own financial situation under control. Cutting expenses is, of course, one of the immediate ways that people can work toward their own best interest. Another way of saying this is that people and businesses are increasing their savings. Every week, more and more articles are appearing informing people how this saving might be accomplished and presenting stories of how households and companies are successfully meeting this challenge.

Furthermore, there are a growing number of stories of people and businesses getting in touch with those they owe money to and working with the lenders to set up terms and conditions that will increase the probability that debt will be repaid in a timely manner. My experience in banking supports the contention that financial institutions and other lenders really would prefer to work something out with those they have lent money to, but depend on those borrowers that perceive that they are going to face some difficulties in the future to get with them and initiate discussions about how things might be worked out. Postponing discussions only puts more pressure on both parties and tends to make things harder to resolve.

Refinancing is another problem looming on the horizon. There seems to be dark clouds hovering over the commercial real estate industry and less credit worthy corporate debt issuers. A lot of debt is going to come due over the next 18 months or so. The big concern is whether or not this debt will be able to be re-financed since very little of it will be able to be re-paid. The bits and pieces of news coming out of this area is that discussions are being held and although there may be failures coming out of these situations that the problems are recognized and will be absorbed in a relatively smooth fashion as time passes.

The areas of the bond market that contain firms with higher credit ratings are performing remarkably well. Volumes of new issues are up and the financial markets have absorbed these rather smoothly. If anything, corporations have turned to the bond market for funding since the commercial banking system is actually shrinking its base of commercial and industrial loans. This is an interesting thing happening to substitute bond credit for the credit extended by the banking sector at this point, but, as they say, whatever works.

Another method for de-leveraging that seems to be picking up steam is that corporations are buying back their own debt off the open market. In some cases it is reported that these companies can buy back their existing debt at 50 cents on the dollar which is a pretty good exchange for the company going forward. Look to see this pick up this fall.

Finally, the Federal Reserve does not look like it is going to pull the rug out from the banking system and the financial markets going forward. Yes, there is a lot of concern about all the reserves the Fed has put into the banking system and whether or not it is going to be able to “exit” the banking system in an orderly fashion. However, the Fed does not want a replay of the 1937-38 experience when it caused a collapse in the banking system by trying to withdraw excess reserves from the banks by raising reserve requirements. (See my post of August 21, “Federal Reserve: Exit Watch”: http://seekingalpha.com/article/157620-federal-reserve-exit-watch.) The best guess here is that the Fed will continue to keep the banking system very liquid in order to help underwrite the de-leveraging now underway.

The important thing to remember at this time is that “quiet is good”! The de-leveraging is taking place. However, the de-leveraging will take time. We just can’t become too impatient for we must let the system do its work and restructure its balance sheets. We just don’t want any more shocks! There still is a long way to go toward a full economic recovery and the other two issues I mentioned in the first paragraph are of great concern. But, we move forward by just putting one foot in front of the other.

The Future of Monetary Policy: The Exit Strategy

The recession seems to be ending. However, many people do not feel that the recovery will be very robust. (See my post “Is the Recession Over?” http://maseportfolio.blogspot.com.)
The crucial claim in the near term though is that the recession seems to be ending.

Because of this the issue that seems on the minds of many people is: how is the Fed going to remove all the bank reserves it has pumped into the banking system over the past ten months? The obvious concern is that the recessionary downdraft would turn into an inflationary nightmare. In other words, these people are asking for an explanation of the “exit strategy” the Federal Reserve plans from its policy of preventing a major economic collapse?

Chairman Bernanke spoke to Congress last week to give some assurance that the Federal Reserve knew what it was doing and would, therefore, do what it needed to do as the economy recovered to keep country from experiencing a wicked bout of inflation. I did not sense a lot of confidence that the hypothesized “exit strategy” would unfold as Bernanke stated that it would.

Bernanke also claimed that the United States economy, although it would begin recovering from the recession soon, would not emerge rapidly. Consequently, the Federal Reserve would have to keep its target Federal Funds rate at the present levels for an extended period of time.

There are two immediate concerns with Bernanke’s presentation. First, the Federal Reserve always tends to react to the economic situation. It does not lead economic events. Simply put, the Federal Reserve will not move in advance of any evidence that inflation is picking up. It will follow such evidence. Furthermore, can you see this Federal Reserve taking on Congress by saying that it is tightening up on monetary policy when economic growth is still moderate or just tepid and unemployment rates are above 8% and inflation has not began to accelerate? This Fed does not have that independence from the political side of the government.

Second, even if inflation does begin to pick up speed increasing rapidly enough to cause some concern in financial markets, can you see Congress accepting an inflation target versus a target for faster economic growth. At no time in post-World War II history has the Federal Reserve crossed a presidential administration or a Congress in the early stages of an economic recovery to follow an anti-inflationary period. This starts right with the “Accord” of 1951 to the present. (The Volcker reign at the Fed does not qualify for this as its timing in the economic cycle was not the same.) The Employment Act of 1948, and as modified, still rules as far as Presidents and Congresses are concerned.

Plus there is the concern over the federal deficit. There will be some form of health care coming along, and an energy policy, and other policy initiatives that will continue to put pressure on the budget of the government. The prospect for further large deficits and a rapidly growing national debt is still a reality that must be faced in the next few years. How is the Federal Reserve going to stay independent of all the Government bonds that are going to be coming to market?

This kind of environment will also encourage private borrowing again, both from businesses as well as the consumer. This kind of environment is inflationary like the early 2000s even if price indices like the Consumer Price Index do not rise dramatically. With private debt soaring along with the debt of the government we will have another period of “credit inflation.”

When the growth of credit exceeds the possible real growth of the economy or if the growth of credit in a particular sector of the economy exceeds the possible real growth of that sector, there is a “credit inflation.” This “credit inflation” can result in an asset bubble as occurred in the housing market earlier this decade where asset prices rose even if “flow” prices, like rents, or, implied rents as estimated for the Consumer Price Index, do not reflect this inflation. In addition, it can result in a substantial deficit in the trade balance and lead to a massive flow of dollars into world financial markets and whether these imbalances in the United States trade deficit will find happy recipients of the dollars, as China gladly seemed to receive dollars earlier on, is a question no one can answer at this time.

There is too much debt already in the financial system and it needs to be reduced. The Fed is trying to do the best it can and I don’t question the “good intentions” of the people that are attempting to get us through this mess. However, the problems are huge and I am not convinced that having good intentions is sufficient to lead us through these times. There is plenty of evidence that there is plenty of pain ahead of us. I am not convinced that Ben Bernanke is the person to create this pain and then lead us through the restructuring of the economy.

The Reappointment of Ben Bernanke to the Chair

There are two reasons I am not in favor of re-appointing Ben Bernanke as Chairman of the Board of Governors of the Federal Reserve System. First, I don’t believe that Bernanke has a plan on how to move the country into the future and I don’t believe that he ever did have a plan to move the country into the future. He was an advocate of “inflation targeting” and a student of the Great Depression. It is not the right time in history to pursue “inflation targeting” and the only thing Bernanke learned from the Great Depression is that if you are going to do something to try and combat a major economic downturn, do it in sufficient magnitude so that no one can say that you erred on the side of doing too little effort.

Second, I believe that the economy is going to have to go through some pain in the near future, a pain that results from the problems related to having too much debt in the economy. To restructure the balance sheets of American finance and industry there are still tough times to go through. I don’t see Ben Bernanke as the inflictor of pain. Paul Volcker was capable of acting in that way and had the personal strength of character to carry it through. Bernanke, in my mind, has neither the ability to inflict discipline on the economy nor does he have the weight of personality to carry it through.

Let’s look at Bernanke’s history. He was complicit with the Greenspan easy money policy that kept interest rates at historically low rates for too long a period of time and created the “credit inflation” that resulted in the housing bubble, the dramatic decline in the value of the United States dollar by about 40%, and the massive flooding of dollars into the world economy. He had no feeling at all for the lending practices in the mortgage sector or for the mess that was evolving in the area of credit derivatives and banking governance. Later on, he continued to follow a policy of fighting inflation when the financial markets were beginning to fall apart. He seemed to react hastily in September 2008 and was not a consistent guide through the bailout of Fannie Mae and Freddie Mac, the collapse of Lehman Brothers, and the strange subsidization of AIG. (See my post of November 16, 2008: http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

I do not know who should replace Bernanke at this time. All I do know is that we have a new administration and a new economic team. Bernanke, I believe, does not have what it takes to get the financial and monetary situation straightened out. I believe that President Obama needs to appoint his own choice as Chairman of the Board of Governors of the Federal Reserve System.

The State of the Banking System

There are three preliminary indicators that the banking system is coming along on its way to recovery. First, there is the “letting go” of CIT Group, Inc. The government must feel that it does not need to extend itself to help out this institution given its present troubles. (See my recent post on the CIT situation: http://seekingalpha.com/article/148730-cit-s-debt-issues-show-why-the-economy-won-t-be-picking-up-any-time-soon.) We’ll see if they continue this approach with other troubled institutions as additional situations arise.

Second, there is evidence that the regulators are taking a harder line at Bank of America and Citigroup. Each has its own problems, but the Feds seem to believe that they can step up their demands on these two financial institutions concerning boards, managements, business affairs, and so forth. They would not do this if they believed the system to be too fragile.

Third, I sense the Federal Reserve backing off from the more aggressive stance it took with respect to the bond markets one to two months ago. This is just a feeling that I will be following up on in the near future.

These actions provide some preliminary evidence that we are in the “working out” stage of the credit cycle where time is the biggest factor to contend with. Bailouts are needed to prevent “liquidity” problems when markets might crumble under cumulative selling pressures. But, this is a short run problem.

The “work out” phase of a financial crisis is the period when institutions still have severe credit problems but are not under short term pressures to relieve their balance sheets of “toxic” or “underwater” assets.

This does not mean that there will not be more failures of financial institutions and some of them may be relatively large ones. What it does mean is that the problems that still exist within the financial sector can be handled in a relatively orderly fashion. So, the banks and the regulators can operate within an environment that does not seem “desperate.” Severely troubled still, but not in a state of panic.

Within this scenario, the questions that remain about the banking system relate to earnings. We have seen Goldman Sachs and JPMorgan Chase & Co. post strong gains for the second quarter. However, most of the gains were attributed to trading activities, with secondary help from their underwriting business. These are not good, solid “banking” results. And, these organizations are highly diversified and can post returns from these areas, something that most other banks in the United States cannot do.

Still, the banking system seems to be in the stage of recovery where current cash flows can allow the individual banks to write off more and more of their loans and other assets over time and thereby restore the integrity of their balance sheets. With the results it achieved in trading and underwriting, JPMorgan Chase was able to take large write downs of home equity loans, mortgage defaults, and credit card charge offs while also increasing the amount of funds it set aside to increase its loan loss reserve. This is what other banks will be doing to reduce the burden of bad assets they are now carrying.

Overall, Total Assets in the commercial banking system grew by 8.9% from June 2008 to June 2009. The capital residual (Assets less Liabilities) in the system grew by 7.6% so that the capital asset ratio of the banking system dropped from 10.2% to 10.1%.

In terms of how the banks are attempting to protect themselves, the Cash assets of Commercial Banks in the United States were up 186%, year-over-year, in June 2009, although this rate of increase is down from a year-over-year rate of increase of 236% increase in May 2009.

Total Loans and Leases in the banking system rose just about 1.4%, year-over-year, in June while Commercial and Industrial Loans actually decreased by 3.1%. Commercial banks are just not lending to businesses which continues the trend which began last year. Banks are lending to consumers, up 5.5% year-over-year (primarily on credit cards and other revolving credit plans), and on real estate, up 6.4% year-over-year (the largest jump coming in revolving home equity loans).

The cash assets held in the commercial banking system declined regularly throughout June as the peak in cash assets held was reached in May. Thus, it appears that banks are backing off from taking everything the Federal Reserve has put into the banking system and stashing it away in “cash accounts”. This is confirmed by the aggregate banking data put out by the Federal Reserve which indicates that total reserves in the banking system dropped throughout June 2009 and the excess reserves also fell from peak levels reached in late May.

Thus, it appears that things are working out pretty much as the Fed hoped they would. (See my explanation of what the Fed has been trying to do, http://seekingalpha.com/article/145913-is-treasury-s-tarp-debt-already-monetized-part-ii.) Of course, the game is not over yet!

Bottom line: the banking system is working through its problems. The Federal Reserve and the regulators seem to be backing off a little, allowing the system to adjust over time to its dislocations. There is still room for a surprise, but, the more time passes, the less likely a surprise is likely to occur. In other words, the unknown unknowns have been substantially reduced and the known unknowns are what we are working on.

The banks are not lending except on established credit lines (credit cards and home equity loans) and there appears to be plenty of liquidity in the system as a whole. Whereas the lack of lending slows up the possibility for an economic recovery, it is an essential component of getting the banking system healthy again which is needed if there is to be any chance of a robust economic recovery in our future.

Explaining the Drop in the Weekly Money Stock Measures

Thursday afternoon the Wall Street Journal came out with a startling headline: “US M1 Fell $16.2 B In June 29 Week; M2 Fell $36.2 B.” (See http://online.wsj.com/article/BT-CO-20090709-714875.html#mod=rss_Bonds.)

Looking at the H.6 release that comes out at 4:30 PM on Thursday afternoon the Journal reported correctly. The H.6 release is titled Money Stock Measures. The seasonally adjusted M1 money stock measure averaged $1,669.1 billion in the week ending June 22, 2009 and averaged $1,652.9 billion in the week ending June 29, 2009, a drop of $16.2 billion. Please note that in the two weeks previous to June 22, the M1 Money Stock measured $1,630.9 billion and $1,656.5 billion, respectively.

Thus, M1 rose by $7.0 billion in the week ending June 15 and by $26.5 billion in the week ending June 22.

In terms of the seasonally adjusted M2 series, the weekly average for the week ending June 22 was $8,385.4 billion and for the week ending June 29 the M2 Money Stock averaged $8,349.2 billion, indicating a $36.2 billion drop. We can note that for the two previous weeks M2 averaged $8370.0 billion and $8,385.2 billion, respectively.

M2 rose by $15.2 billion in the week ending June 15 and by $0.2 billion in the week ending June 22.

Now let’s see what happened to the non-seasonally adjusted data. The M1 money stock rose $29.5 billion in the week ending June 15, by $52.0 billion in the week ending June 22 and rose another $47.9 billion in the week ending June 29. These figures are significantly different than the seasonally adjusted series.

In terms of M2, this series rose by $16.4 billion in the week ending June 15 but it dropped by $74.4 billion in the week ended June 22 and dropped again by $49.0 billion in the week ending June 29. Again there are serious differences.

There are two points to make here. Formerly the Fed did not put out weekly data on the Money Stock Measures because they jumped around so much. Such volatility can be unnerving to people watching the money stock. Obviously, people at the Wall Street Journal reacted very strongly to the weekly release.

Second, trying to seasonally adjust weekly data is only for the foolhardy or for the very brave. The only conclusion I can draw from the behavior of both the seasonally adjusted series and the non-seasonally adjusted series is that a lot of “stuff” is going on and the seasonal adjustment process is doing very little to capture what is going on. That is, what we are seeing here is white noise!

Is there any clue to what might be happening to banking accounts?

The answer to this is yes, there have been things happening that might help to account for some of the swings and because of the uncertainty of exactly when these things happen from year-to-year their movements can “screw up” the seasonal adjustment of the raw series.

To see what might be happening in the banking system, I go to the Federal Reserve release H.4.1, “Factors Affecting Reserve Balances.” This release also comes out at 4:40 PM on Thursdays. The account I am particularly interested in on the Fed statement is the line item called U. S. Treasury General Account. This is the account that the Treasury Department pulls in tax money from the private sector and then pays it out to the private sector. It is the “transaction” account of the Treasury Department, the one in which the Treasury deposits tax money and the one which the Treasury Department writes checks against.

This account is a “Factor that is absorbing reserves.” That is, when the Treasury draws funds in from the private sector it removes reserves from the banking system. When the Treasury writes checks to the private sector and these balances at the Fed decline, reserves are put back into the banking system.

The Fed and the Treasury work hard to coordinate their actions because they don’t want to incur large swings in the bank reserves. So, what happens is that tax payments and such are kept in the banking system until the Treasury is about to write some checks. When it draws funds from the banks, private deposits go down and the Treasury balances at the Fed go up. When the Treasury turns around and sends out checks to the private sector, bank deposits go up and the Treasury balances at the Fed go down. The Fed then manages bank reserves so that there are few if any dislocations caused in the banking system due to these transaction.

What we have here in June is a buildup in balances at the U. S. Treasury General Account and then a draw down as the Treasury writes out checks. What the Wall Street Journal caught was the building up deposits in the Treasury account. This comes out in the releases up to June 29.

However, we have not yet see the affect of the Treasury checks going out because we don’t have more current data on the Money Stock measures. We do have data for the Treasury’s General Account for the banking weeks ending July 1 and July 8.

And what do we see?

In the banking week ending June 10, the Treasury account averaged $31.4 billion. The next week the account averaged on $42.3 billion, but the account AT THE CLOSE OF BUSINESS on June 17 was a whopping $132.8 billion. Most of the money was drawn from the banking system at the end of the banking week so that the average did not move much.

But, for the banking week ending June 24, the Treasury General Account balance averaged $118.7 billion reflecting the growth in deposits, but the account AT THE CLOSE OF BUSINESS on June 24 stood at $78.8 billion. A lot of money passed though this account in a very few days.

The U. S. Treasury General Account then continued its decline. The average balance for the banking week ending July 1 was $72.0 billion and the average balance for the banking week ended July 8 was $34.2. This latter figure was right at the level of the average balances in the account in the first two weeks of June.

So, as the Wall Street Journal reported, we saw a massive decline in both measures of the Money Stock in the week ending June 29. However, the swings were caused by operational transactions within the government and should be reversed out in the data that are released for the weeks ending July 6 and July 13. But we won’t see those data for another two weeks.

Bottom line: the money stock is not collapsing! Whew!