Developments in the Banking Sector: Large Amounts of Funds Still Going to Foreign Institutions

There seem to be three major stories in commercial banking these days: first, the cash going to foreign-related institutions; second, the pickup in non-real estate business lending; and three, the continued weakness in consumer borrowing.

Excess reserves at depository institutions in the United States averaged $1,509 billion in the two weeks ending January 25, 2012.  Cash assets at commercial banks in the United States were $1,597 billion in the week ending January 25, 2012.

In December 2010, excess reserves were $1,007 billion and cash assets $1,082 billion. 

Both excess reserves and cash assets rose by about 50 percent during this time period.

In recent years excess reserves at depository institutions and cash assets held by commercial banks have moved closely together.  The reserves the Fed has injected into the financial system have gone primarily into cash assets. 

It is interesting to note that of the $590 billion increase in cash assets at commercial banks, $403 billion went onto the balance sheets of foreign-related institutions in the United States.

For the week ending January 25, 2012, roughly 47 percent of all the cash assets held in commercial banks in the United States were held on the books of foreign-related institutions.  This is up from about 32 percent in December 2010. 

Note: These foreign-related institutions hold only 14.5 percent of the total assets in the United States banking system (up from about 11 percent a year earlier) so they are now holding a disproportionate share of the cash assets in the banking system.   

 

On the liability side of these foreign-related institutions there was a net increase in “net (deposits) due to foreign offices of $625 billion and a decrease in US held deposits (large time and other deposits) of $185 billion.  Thus, the right side of the balance sheets of these foreign related institutions rose by a net amount of $440 billion related to movements of funds “offshore”, i.e., primarily to Europe.

The Federal Reserve has not only supplied liquidity to the European continent through dollar swaps with foreign central bank, it has supplied funds to international financial markets through its open market operation.

It is not expected that many of the funds going to these foreign-related financial institutions will go into loans in the United States market as these institutions only hold about 8 to 9 percent of all commercial loans in the United States.

Therefore, when we look at what the Federal Reserve has done, we have to realize that only about fifty percent of the funds the Fed has injected into the banking system has gone to domestically chartered banks.  It is only this domestic portion of the Fed’s injection of funds that can have the greatest possibility of impact on business lending and hence economic growth.

Cash assets did increase at domestically chartered commercial banks during this time period: the increase was about $112 billion as total assets grew by $243 billion.  At the largest twenty-five banks in the country, the increase was $75 billion in cash assets and $130 billion in total assets.

The important thing is that business loans (Commercial and Industrial loans) at commercial banks have been increasing, primarily at the largest twenty-five domestically chartered banks in the United States.  From December 2010 to December 2011, C&I loans rose by $123 billion in the commercial banking system, with $94 billion of this increase coming at the largest twenty five banks, a 15 percent year-over-year rate of increase. 

Business loans did increase at the rest of the domestically chartered US banks, but they rose by only about $18 billion or about 5 percent year-over-year.

Over the past thirteen-week period, however, C&I loans at these smaller banks hardly increased at all and actually fell over the last four-week period.

At the largest banks, business loans continued to rise over the past four weeks ($15 billion) and over the past thirteen weeks ($35 billion).  My question about these increases has to do with the uses that the funds are being put to.  The national invome statistics showed that inventories increased in the latter part of last year and these loans could have gone to increase the inventory buildup.  Many economists seem to believe that given the weak consumer behavior (see below) that the inventories will decline in the first quarter of 2012 and this will result in some weakness in business loans.  Alternatively, some of the borrowing could be so that corporations could buildup cash positions for either acquisitions or for stock repurchases.  There does not seem to be any inclination to increase spending on business plant or equipment.

Commercial real estate loans continue to decline at the smaller banks in the country although there has been a pickup in these loans at the largest banks.  All-in-all, lending on commercial real estate continues to go down: and given all the loans that will mature over the next 12 to 18 months, with many of them being unable to re-finance, there is a continued likelihood that these loans will continue to decline in the near future.    

On the other hand, residential mortgage lending rose across the board at commercial banks.  Although residential mortgages fell on the books of the banks from December 2010 to December 2011 by $12 billion, over the past thirteen-week period, these mortgages grew by almost $19 billion, with $11 billion of this increase coming in the last four weeks.  And, the increases came in all sizes of banks.

This line item will be interesting to watch over the upcoming months since housing prices continue to decline and foreclosures and bankruptcies seem continue to occur at a rapid pace.

Just a further note on real estate lending: home equity loans have declined over the last thirteen weeks and held roughly constant over the past four.  

Counter to this increase in residential spending is the decline in the dollar amount of consumer loans on the books of the banks.  Over the past six months consumer lending has dropped by a little more than $6 billion with a major decline of roughly $15 billion coming over the last four weeks.   Most of this decline has come in credit card debt outstanding at the banks. 

This information on consumer lending seems to point to a continued weakness in consumer expenditures. 

In terms of the domestic economy it seems as if there is not much encouragement for a stronger economic recovery in the banking numbers.  There seems to be little demand for any kind of loans in the current environment, but, one also gets the feeling that the banks, especially the smaller ones, are not willing to lend even if there were an increasing demand for loans. 

Where is the US Consumer?--Part 2

Two pieces of news today that go along with my earlier post about the pressures families are facing in the United States. (http://seekingalpha.com/article/328252-where-is-the-u-s-consumer).   

First, “Home Prices Tumble.” (http://professional.wsj.com/article/SB10001424052970204652904577194752102528744.html?mod=WSJ_hp_LEFTWhatsNewsCollection) “For November, the Case-Shiller index of 10 major metropolitan areas and the 20-city index both fell 1.3% from the previous month. David M. Blitzer, chairman of the index committee at S&P Indices, also noted that 19 of the 20 major U.S. metropolitan markets covered by the indices in November saw prices decline from October…

The 10-city and 20-city composites posted annual returns of negative 3.6% and negative 3.7%, respectively, compared with November 2010.”

Second, “Consumer Confidence Unexpectedly Declines.” (http://blogs.wsj.com/economics/2012/01/31/consumer-confidence-unexpectedly-declines/)  “U.S. consumer confidence in January gave back some of the huge gains posted in the previous two months, according to a report released Tuesday. Views on labor markets darkened.

The Conference Board, a private research group, said its index of consumer confidence retreated to 61.1 this month from a revised 64.8 in December, first reported as 64.5. The January index was far less than the 68.0 expected by economists surveyed by Dow Jones Newswires.

Perceptions about the job markets worsened this month. The survey showed 43.5% think jobs are “hard to get” up from 41.6% saying that in December, while only 6.1% think jobs are “plentiful” down from 6.6% in December.”

These data are consistent with the material presented in the earlier post.  The United State consumer has lots to worry about and, for a large portion of this consumer base, spending is not expected to be very robust in future months.  And, their situation cannot be turned around soon by either monetary or fiscal policies. 

Where is the US Consumer?

“Rising Income is Saved, Not Spent,” reads the Wall Street Journal Tuesday morning. (http://professional.wsj.com/article/SB10001424052970204740904577192702993936344.html?mod=ITP_pageone_1&mg=reno-secaucus-wsj)

“Personal income increased 0.5% in December from November adjusted for seasonality, the largest monthly increase since March…but spending was flat over the month—actually fell when inflation is factored in.”

“The savings rate, around 5.0% for the first half of 2011, was near 4.0% for much of the second half of the year…. Economists warned that consumers would soon resume socking away cash at the expense of spending, and that appears to be playing out now.”

With unemployment still high and the housing market in the doldrums, consumers are reluctant—and in many cases unable—to increase their spending in a big way.”

The Federal Reserve’s recently released forecast projected unemployment rates remaining at high levels through 2014, declining only slightly throughout the next three years.  And, even worse, underemployment is also expected to remain high with the rate of underemployment staying near to one out of every five people of working age.  No help coming here.(

Furthermore, a large proportion of homeowners still find themselves “under water” with mortgages that exceed the market value of their houses.  This situation is not expected to improve in the near future.

Robert Shiller, the Yale economist, was just interviewed at Davos and responded to questions about home prices by saying that prices will probably continue to decline, although not at the rate they declined in recent years.  He added that even if housing prices did stop declining, there is no reason to expect that they would start to rise anytime soon.  In addition, he added, that even though housing prices were returning to something more like a “fair value” that historically, the tendency was for the market to “overshoot” the “fair value” until all the previous exuberance is wrung out of the market. (http://professional.wsj.com/article/SB10001424052970204740904577192702993936344.html?mod=ITP_pageone_1&mg=reno-secaucus-wsj)

A White House effort to lessen the impact of these homes that are “under water” seems to have failed in that the program developed by the administration has not reached enough borrowers to have much impact on the market. (http://www.ft.com/intl/cms/s/0/cf9fed00-4a89-11e1-8110-00144feabdc0.html#axzz1l2qSCMaM)

Even more chilling is the report released today by the Corporation for Enterprise Development (CFED) titled “The 2012 Assets & Opportunity Scorecard: How Financially Secure are Families?” (Go to http://cfed.org/.)   This study presents what it calls the households that are in “liquid asset poverty”.  A household is considered in liquid asset poverty if it owns a home, yet has no savings to speak of.  These people are just one significant emergency away from a real financial crisis. 

The emergency could take the form of a major car breakdown or a health problem.  Most of these people are earning a regular paycheck, CFED says, but they don’t really realize how close to the edge they are living.  Many have some other form of debt, but in an emergency would have to rely on very expensive sources of debt to try and carry them through the emergency. 

The study reports that 43 percent of the households in the United States are liquid asset poor.  This amounts to roughly 128 million households. 

Again, we seem to see the country bifurcating.  There are those households that are doing OK and are continuing to spend through these tough times.  Yet, there are a large number of people that have to watch out where every penny of their income is going.  This means that the economic recovery will not only remain week, but it will be fragile and susceptible to unexpected shocks.

Saving and deleveraging are still needed and being sought by many families, but this will just mean that the recovery will be missing any strong support from consumer spending in the near term.

And, it means that banks and other financial institutions cannot be sure of value of many of the assets on their balance sheets, both mortgages and consumer loans, but also face the fact that loan demand will also not be strong in the future.

We are still looking for where the surge in economic activity will come from.    

Does Getting Out of Debt Mean that People Should Start Spending More?

From the Wall Street Journal this morning:

“U.S. families—by defaulting on their loans and scrimping on expenses—shouldered a smaller debt burden in 2010 than at any point in the previous six years, putting them in position to start spending more.

Total U.S. household debt, including mortgages and credit cards, fell for the second straight year in 2010 to $13.4 trillion, the Federal Reserve reported Thursday. That came to 116% of disposable income, down from a peak debt burden of 130% in 2007, and the lowest level since the fourth quarter of 2004.” (See “Families Slice Debt to Lowest in 6 Years,” http://professional.wsj.com/article/SB10001424052748704823004576192602754071800.html?mod=WSJPRO_hps_LEFTWhatsNews.)

The logic in this is that people reduce debt so that they can spend more. I think that is called a “non sequitur”.

If people (and businesses) get more and more in debt over a fifty year period (as they have since 1960) and this contributes to the worst recession since the Great Depression the objective of these people (and businesses) getting out of debt is so that they can get more in debt once again?

I thought that if people (and businesses) got themselves so leveraged up and so “over-extended” that they found themselves in serious financial trouble and were faced with foreclosure on their real estate and personal (or business) bankruptcy that what they would try and do is bring their debt more in line with their incomes so that they could manage their debt.

I thought that maybe people (and businesses) would become more prudent and try and manage their debt in a way that would allow them more “peace of mind” not having to scramble to make principal or interest payments every month.

And we read that there are 11 million people who find themselves owing more on their mortgages than their home is worth on the market.

And we read that about one out of every four individuals of working age is under-employed.

And, we read that the income distribution is skewed toward the high income end worse than it has ever been in the history of the United States.

And, we read that America is bifurcating more and more based on education and race.

And, we read that many state and local governments can’t meet their pension commitments and can’t balance their budgets so that they are cutting jobs, cutting pensions, and cutting education.

Some people are spending. Some people are using credit again. Some people are buying very nice homes. Some people are paying for very expensive educations.

But, this spending and credit extension is not across the board.

The inflation over the past fifty years created the ideal environment for debt creation. The inflation was not large enough to create a panic. From time-to-time, the inflation was not enough to really see.

Yet, from 1960 to the present time, the purchasing power of the dollar has fallen by 85%. The dollar that could buy a dollar’s worth of goods in 1960 can only buy about fifteen cents worth of goods now.

This was the perfect scenario for the creation of credit, for financial innovation, and for the growth of the finance industry.

This could not have been a better environment for the consumer culture to thrive where people could feed their insatiable appetites for goods and think that things were great.

And, now a substantial part of our economy is mired in this debt and struggling hard to get their heads above water. They don’t need to pile on more debt…they need some stability and consistency to their lives.

Yet, many are pushing to get the “credit machine” going again. The federal government is setting the standard (as it has over the past fifty years) by living way beyond its means and threatening to increase its debt by $15 trillion or more over the next ten years.

The Federal Reserve has pumped almost $1.4 trillion in excess reserves into the banking system in order to get the banks’ lending again.

We want families to be “in position to start spending more” as the Wall Street Journal article stated.

A credit inflation is just what is needed.

Each time we restart the “credit inflation” button again, more and more people seem to be in a position in which they are excluded from its benefits. They are under-employed, substantially in debt, and excluded from benefitting from further increases in prices.

This means each time the “credit inflation” button is pushed again, only a smaller proportion of the population can participate in subsequent expansion.

Maybe this is why it is taking us so long to get the economy “moving again.”

History has shown that this “show” cannot go on forever. The difficulty is in knowing just when the “show” is over.

The government is trying to start the music playing again. And, those that can are supposed to begin dancing. But, maybe this time only the financial industry will be dancing (http://seekingalpha.com/article/255748-will-the-financial-industry-dance-alone).

No Housing Recovery In Sight

Households, as a group, are gaining ground financially, but are still far below where they were in 2007. This, along with other weaknesses in the economy, is going to continue to contribute to the weakness in the economic recovery now taking place.

One place this weakness is particularly evident is in the housing sector. The recovery of the housing market helped to lead the economy out of every previous recession in the post-World War II period. In the recent experience, this has not been the case, even with special incentive programs created by the federal government to spur along a rebound.

The figure on housing starts in May 2010, an annual rate of 593,000, confirmed this continued weakness.

The recession ended in July 2009, yet housing starts have hovered around a 600,000 unit annual rate ever since. The highest figure recorded during this time period was an annual rate of 659,000 in April of this year, but the pace dropped off once again in May.

At this time, Americans are just not in a position to acquire housing. If we look at the financial position of United States households since the year 2007, according to the Flow of Funds accounts released by the Federal Reserve, the net worth of households has decline by slightly less than $10 trillion. Year-over-year, from the first quarter of 2009 through the first quarter of 2010, household net worth has risen by a little more than $6 trillion, but almost all of this increase has been in the value of equity shares, something that is not a part of the balance sheets of Main Street America. The value of tangible assets, including the value of homes, has fallen by $5 trillion since 2007 and increased only modestly year-over-year. Again, the beneficiary of any gain here has not been Main Street America.

The plight of the American household is captured in the percentage of households owning their own home and who actually have no equity in the home they are living in. David Wessel captures this dilemma in his Wall Street Journal article this morning, “Rethinking Part of the American Dream,” http://online.wsj.com/article/SB10001424052748703513604575310383542102668.html?mod=WSJ_hps_RIGHTTopCarousel_1. He cites data from the Federal Reserve Bank of New York: for example, in San Diego, 55% of households owned their own home, but the fraction of these households that had equity in their homes was between 35% and 39%; in Las Vegas, only 15% to 19% of households had equity in their homes, even though 59% of those households owned their own home. In the cities reported, Boston, Chicago, and Atlanta scored the highest in owners having equity in their own home.

And, with one out of every four or five working age people being under-employed, it is highly unlikely that there will be a stronger recovery in the housing market in the near future.

Ethan Harris of Bank of America Merrill Lynch is quoted as saying “We’re not going to see a real recovery in the housing market until the foreclosure process gets worked out. That’s…a 2012 event.” (http://online.wsj.com/article/SB10001424052748704009804575309692681916212.html?mod=WSJ_WSJ_US_News_5)

Delinquencies on mortgages seem to have leveled out but they still remain at a high level. Also, foreclosures remain at a high level.

The performance of loans that have been restructured remain dismal: see my post “Eventually Debt Must Be Repaid, http://seekingalpha.com/article/210365-eventually-debt-must-be-repaid. Sixty-five to seventy-five percent of the loans restructured in the Treasury’s loan restructuring plan “re-default.”

And, banks continue to stay on the sidelines in terms of making new loans, especially mortgage loans. With one out of every eight commercial banks on the FDIC list of problem banks and many more on the edge, housing is just not going to show much bounce in upcoming months.

Households, according to the Federal Reserve data, are reducing the amount of debt outstanding, but at a relatively slow pace. This is where, I think, it is important to think about how the country is dividing along two lines, between those that are doing quite well, thank you, and those that are really struggling.

As I mentioned, the value of the financial assets of U. S. Households rose by about $5.5 billion last year, most of the increase coming in the market value of equity shares. However, those benefitting from the rise in the value of equities are generally not the ones that own a home with no equity in it. They are generally the people that are still employed and have a sufficient income. Also, they are not the ones that are in debt in a major way.

In my post on debt repayment, I quoted a report by Fitch Ratings Ltd. indicating that the individuals that were in the mortgage re-structuring program were also heavily in debt on credit cards, car loans, and other obligations. People in this second group are the ones that are excessively in debt and have neither the accumulated wealth nor the current income to pay down their debt.

It is this debt that still must be worked off before the recovery can have any bounce to it. Resolving this debt burden will also go a long way to helping the banking system regain its legs.

Consumer spending may increase modestly, housing starts may gain some, but the Americans that are in this second group will not be the ones contributing to these increases until they get their finances back in order and that may take a long time. To see this in another way, check out what is actually being purchased by consumers. Much of it is up-scale, not ordinary “stuff.”

The Plight of Consumers

The “consumer” is spending. Retail sales jumped 1.6% in March led by auto sales, clothing and furniture. "There's a growing risk that we're underestimating the strength of the recovery," said Stephen Stanley, chief economist at Pierpont Securities, noting that deep recessions tend to be followed by steeper recoveries. "If the economy pops, it's going to be faster than anyone is forecasting." (From Thursday’s Wall Street Journal article “Evidence Mounts of Strong Recovery,” http://online.wsj.com/article/SB20001424052702304798204575183683432202678.html#mod=todays_us_page_one.)
The only reason I can give for this spending growth is that with interest rates being so low, some consumers just don’t want to hold onto financial assets. They would rather be spending their funds than keeping them in banks or other financial institutions earning practically nothing on their savings.

For sure, the consumer is not borrowing. Total consumer loans are down: according to the Federal Reserve, they declined by 4.4% in 2009. Total consumer loans are down, year-over-year, for the first quarter of 2010.

To keep up their spending, consumers are drawing on their accumulated wealth by reducing the funds they hold in time accounts at financial institutions, retail money funds, and institutional money funds. Again, according to Federal Reserve statistics, small-denomination time deposits at financial institutions are down by more than 22%, year-over-year, in March 2010. Retail money funds are down by over 27% in that same time period and institutional money funds have fallen by more than 19%. (Also see this article in the Wall Street Journal “Money Funds Decline Anew”:

http://online.wsj.com/article/SB10001424052702304628704575186411611685980.html?KEYWORDS=john+kell.)

We can track these declines in the non-M1 component of the M2 measure of the money stock.

Although the savings deposit total of the non-M1 component of M2 has increased by 13% year-over-year in March, all non-M1 M2 is showing a negative year-over-year rate of growth.

These funds are going into demand deposits at commercial banks and other checkable deposits at financial institutions. These are increasing, year-over-year, at a 14% and 20% rate, respectively.

Consumers are seriously moving their assets into transactions accounts as opposed to interest earning uses. The interest rates are just too low on these latter items to be attractive.

The consumers have used some of these funds to pay down consumer loans at banks and to reduce credit card balances. There is some indication that delinquencies are starting to moderate or even decline in this area. (See “Rocked by Bad Loans, Card Issuers Stabilize”: http://online.wsj.com/article/SB20001424052702304510004575185982637831398.html#mod=todays_us_money_and_investing.)
Still, consumers are facing huge problems going forward with respect to the ownership of their homes. Estimates are that one out of five home owners are “underwater” now on their mortgages. Foreclosures continue to rise: in the first quarter of this year, 930,000 foreclosures were recorded, up 7% from the fourth quarter of 2009 and 16% above the first quarter of 2009. Records indicate that 6.0 million borrowers are more than 60 days delinquent on their loans.

This is putting tremendous pressure on the small- to medium-sized banks in this country. (See “Small Banks See Recovery A Bit Further Down Road”: http://online.wsj.com/article/SB20001424052702304628704575186493769883092.html#mod=todays_us_money_and_investing.) The current practice seems to be: If you don’t make a loan, it can’t turn bad on you! It is hard to see consumer credit picking up soon.

I find it hard to be enthused by the numbers on retail sales, so I must be out-of-sync with these other economists that take away so much optimism from the March numbers.

One piece of information we don’t have with respect to these numbers. It is hard for me to imagine that a person out-of-work or under employed would take the liquid assets they have and spend it on cars, or clothes, or furniture, or restaurants. We still have close to 10% of the work force unemployed and close to 18% of the working age population under-utilized. And, some believe that under-employment could be closer to 25% because of reporting problems. I can’t imagine that these people are going in for “big ticket, discretionary items.”

People that have jobs, that have accumulated wealth, and that manage their assets well see that keeping money in assets that pay less than 2% annually is not very attractive relative to taking out a car loan which, according to Federal Reserve statistics, costs around 5%. In fact, it doesn’t appear that this type of person is very interested in keeping their money in financial assets that pay this little interest at all.

So, this would indicate that we are observing another way in which the American society is bi-furcating. Those that have the wealth and the jobs are continuing to spend, especially in the current interest rate regime that is being pursued by the Federal Reserve. Those that lack these supports are continuing to withdraw as they face the myriad financial difficulties the previous credit-inflation imposed upon them.

The big banks are booming relative to their smaller counterparts due to the interest rate policy followed by the Fed. Those with the wealth and jobs are also prospering relative to their counterparts due to the same policy.

What Do The Money Stock Figures Tell Us?

The two basic measures of the money stock continue to grow at rapid rates. The broader measure of the money stock has continued to grow at a relatively steady pace. In the fourth quarter of 2008, the M2 measure of the money stock grew at an 8.2% year-over-year rate of increase. (I use non-seasonally adjusted data in all cases relying on year-over-year calculations to take account of seasonal movements in each series. Thus, I don’t rely on the artificial statistical adjustments that produce the seasonally adjusted series.) In the first quarter of 2009 the M2 year-over-year rate of growth was 9.5% but the rate of increase dropped back down to 8.7% in the second quarter.

These growth measures are high historically, but only modestly higher than the rates of growth that were being achieved before the Federal Reserve began pumping up its balance sheet in September and October of 2008. The important thing is the changes that have taken place within this broad measure of the money stock. The movement has been from time and savings accounts to transaction accounts as people have moved their funds from accounts that are interest-earning to those that are basically used to make payments.

The first look at a smaller component of the M2 money stock is to examine the performance of the M1 money stock. For the first half of 2008, the M1 money stock hardly grew at all on a year-over-year basis. But, in the third quarter this measure began to increase as the financial meltdown occurred. For the third quarter the M1 money stock grew at a 3.1% year-over-year pace, but this jumped up to 11.4% in the fourth quarter, followed by a 13.4% growth rate in the first quarter of 2009 and a 16.3% rate of increase in the second quarter.

The monthly year-over-year growth rates for April, May, and June of 2009 were 15.1%, 15.3% and 18.4%, respectively. Something is happening within the M1 measure of the money stock that is not happening to the non-M1 component of the M2 money stock which remained relatively flat during these three months.

What is growing?

Well, demand deposits at commercial banks grew by 44.3% year-over-year, in June 2009, up from 33.1% and 34.5% in April and May, respectively. This is also up from slightly under 30.0% for the first quarter of the year. People and businesses are moving their money into transactions accounts in order to have funds available to meet their day-to-day spending needs.

We see a similar jump in “Other Checkable Deposits” at commercial banks and thrift institutions as these accounts were growing by more that 12.0% in June 2009, up from 6.5% and 7.2% in April and May, respectively. In the first quarter of the year these accounts were only increasing at around a 2.5% to 3.0% rate of growth.

Another component of the M1 money stock is also increasing quite rapidly. Coin and currency held outside of commercial banks has been steadily rising by more than 11.0% year-over-year every month in 2009. A year ago the pace of growth in coin and currency was about one-half of what it is now. Again, one can only draw the conclusion that people are buying more and more things with cash now than they were a year ago. This is another indication of the fact that so many people are unemployed or are going bankrupt.

Where are the funds going into transaction accounts coming from?

The sources of these shifts seem to have been from primarily two areas, Small-denomination time deposits and retail money funds. There has been a drop of about $90 billion in deposits in retail money funds over the past twelve months. The decline in these accounts, year-over-year, is now about 8.5%. The rate of increase in small-denomination time deposits has dropped by 50% in the last six months and there has been an outflow of about $110 billion from these accounts since December 2008.

The conclusions one can draw from these data, I believe, are very clear. People and businesses have become much more conscious of their need to have cash and deposits available for meeting their daily living needs. People and families are moving funds from their small, low interest-earning accounts where they have not been earning much at all. These same people and families seem to be leaving funds in bigger accounts that earn higher rates of interest. It will be interesting to see what happens to these accounts in upcoming months if unemployment continues to rise and bankruptcies remain at high levels. In addition, businesses have found that other short term sources of funds are not available and so have had to become more liquid in order to satisfy their cash demands.

One could argue that the actions of the Federal Reserve have had little stimulative impact through the banking system since the rate of growth of the M2 measure of the money stock has only increased slightly so that the rapidly increasing rate of increase in the M1 measure of the money stock has resulted from individuals and businesses redeploying their short term assets.

This conclusion is reinforced by the information repeated in my July 16, 2009 post on “The State of the Banking System.” (See http://seekingalpha.com/article/149272-the-state-of-the-banking-system.) Commercial banks are not lending except in to consumers and just to consumers that have pre-arranged lines of credit like equity lines on homes and credit cards. This just supports the argument that people are doing what they can to make day-to-day ends meet. And, commercial and industrial loans have actually declined on a year-over-year basis. The argument can be made that no one is going to do anything that would lead one to conclude that economic units are going to increase their spending in a way that will stimulate the economy.

We need to continually watch what is going on in the banking sector. We are going to watch for further changes in behavior that might indicate the changing decisions of families and businesses. Of course, things could get worse and we need to watch for that. But, if things are going to get better, one place to look for changes in behavior is to watch where people are allocating their short term funds and whether or not banks are beginning to lend again. However, it doesn’t seem as if this change for the better will appear soon.

Households and the Debt Problem

The Federal Reserve released new data on the financial condition of the household sector of the United States. Like other sectors of the economy, the financial condition of this sector has deteriorated over the past year.

The value of household assets dropped about 15% falling from $77.3 trillion to around $65.7 trillion. Most of the decline came from the fall in housing values and in their stock market portfolios.

In terms of household holdings of stocks, the value of the stocks households owned, mutual funds that were held and funds in retirement plans, the loss was $8.5 trillion. That is, the value of stock holdings fell from $20.6 trillion to $12.1 trillion.

Although mortgage credit fell during the year, total household liabilities stayed roughly the same at about $14.2 trillion. This means that debt as a percentage of assets rose from around 18% to 22% during the year (or net worth as a percentage of assets dropped from 82% to 78%).

Mortgage credit at the end of 2008 was $10.5 trillion so that other household liabilities totaled around $3.7 trillion, with consumer credit making up $2.6 trillion of this latter number. Mortgage credit fell during the year, but not because the household sector was trying to get out of mortgage debt. The primary reason for the decline was foreclosures and the reduction in the willingness of financial institutions to lend.

What this means is that households took on increased leverage during the year, not because they wanted to in order to grow their balance sheets, but because of the decrease in the value of their assets and because of the need to borrow due to lower incomes. The increased leverage was a result of the collapse of the mortgage market, in particular, and the economy, in general. The increased leverage just happened—it was not planned.

In order to protect themselves in the face of these changes, households moved assets into cash and cash equivalent accounts. Banks deposits held by households were at about $7.7 trillion at year end.

This is important information for understanding the state of the economy and the contribution the household sector might make toward turning the economy around. The household sector was in free fall in 2008 and was reacting to events, not leading them.

Households took three major shocks last year: first was the decline in housing prices; the second was the rise in unemployment; and the third was the fall in the stock market. Not only was their cash flow significantly hurt, but the value of their assets fell precipitously. They borrowed in an effort to hold on and they became more liquid so as to be prepared for that “rainy day.”

The year 2009 does not look any better than 2008. Housing prices continue to plummet. The stock market has dropped since the first of the year. And, unemployment has ratcheted up. That is, one can assume that the direction observed in the balance sheets of American household in 2008 will continue to be followed this year. Even if the stock market were to stabilize or rise through the rest of the year consumer spending, I believe, will continue to be weak. Even if housing prices stabilize. Even with the implementation of the Obama stimulus plan.

According to the best information we have there are three further shocks looming on the horizon. The first two have to do with the mortgage market: over the next 18 a large amount of Alt-A and Options mortgages are supposed to re-price. Given the weakness in employment that is expected to continue and the lower household incomes, this event could be devastating. And, on top of that credit card delinquencies are rising and these are expected to grow given the financial condition of the household sector.

Consumers will continue to withdraw from the marketplace as they add debt where they can in order to maintain at least a part of their former living standards. Also, consumers will continue to try and become more liquid so that they can be prepared should they need to need cash to tide them over a rough time. Any improvement in the stock market will be met with households selling more stock so as to move the funds into more liquid assets, the rise in the market making it easier for them to get rid of stocks—even at a loss.

And where are the funds going to go that come to households from the Obama recovery plan? My guess is that a good portion of them will go into liquid assets, or into paying down debt. Households are scared right now. They are going to use whatever they have as conservatively as possible. This even goes for those that have some security in their employment condition.

The data that are coming out confirm the strength of the problem that the policy makers face. The United States has a tremendous debt overhang. This debt problem is going to have to be worked off. Economists talk about “the paradox of thrift”, the problem that consumers are not spending at this time and probably will not spend much in the near future, even though if everyone opened up their pocketbooks and spent, everyone would be better off.

This situation is like a “Prisoner’s Dilemma” game. If everyone else increases their spending reducing their savings and, willingly, increasing their debt and I don’t follow their lead, then I will be a lot better off that all these other people. But, if everyone else believes as I do and doesn’t reduce their savings and doesn’t increase their debt, then I end up losing big to everyone else. So, as in the “Prisoner’s Dilemma” everyone defaults to the decision to save more where they can and to pay off their debt. The consequence of this will be that consumer spending will remain weak and much effort will be extended, where possible, to work themselves out of debt.

The overall problem is that there is too much debt outstanding. The policy makers are focusing upon stimulating the economy by increasing spending. If the debt overhang is truly too great, then the stimulus package will only have a small multiplier effect on the economy as households try and get their balance sheets back in some kind of order.

Such behavior will not have much affect on the economy, and it will also not have much affect on the stock market. Government policy makers must direct more attention to resolving this debt problem. It seems to me that this is what the financial markets are trying to tell them. As Citigroup and Bank of America claim they are showing some signs of profitability. As General Electric survives a reduction in its credit rating, meaning that GE Capital has more of a chance to re-structure itself. As General Motors indicates that it has reduced costs sufficiently to rescind the request for another $2 billion from the government in March. And, as other financial institutions seek to repay to TARP money they had received last fall, the stock market rebounds.

It is the debt problem that is the big concern of the financial markets. In my opinion, as long as the government policy makers put their primary focus on stimulating spending, the financial markets—and the economy—will continue to flounder. When they refocus on the more crucial problem they will find that the financial markets will be more supportive of what they are doing.