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. 

What Economic Growth in the United States? And, in Europe?

The Congressional Budget Office (CBO) just released its forecast for economic growth and what it sees seems to differ substantially from what the Federal Reserve sees.

The CBO forecast places economic growth (real GDP growth) for the United States at 2.0 percent this year and at 1.1 percent in 2013. (http://www.nytimes.com/2012/02/01/us/politics/deficit-tops-1-trillion-but-is-falling.html?_r=1&ref=todayspaper)

The Federal Reserve just released its projections last week.  Taking the average of the ranges given, the Fed is forecasting that economic growth in 2012 will be 2.5 percent, and, for 2013 will be 3.0 percent.

Hey, these forecasts are going in opposite directions!

The one forecast, that of the CBO, emphasizes the future of the federal deficit: “The deficit will be $1.1 trillion in the current fiscal year, about $200 billion less than in 2011, and will fall sharply in the next three years as a result of tax increases and spending cuts required by existing law…”

The other forecast, that of the Federal Reserve, emphasizes the future of interest rates: short-term interest rates will remain close to zero until well into 2014.

In one sense, it seems as if the consequences of the two forecast are backward.  In order for the deficit to decline, the economy needs to be growing so that tax revenues will increase and welfare payments will decrease.  This will not happen if economic growth slows and unemployment increases…as it does in the CBO projection. (See a strong argument on this point, http://professional.wsj.com/article/SB10001424052970204740904577195352148844134.html?mod=WSJ_Opinion_LEADTop&mg=reno-secaucus-wsj.)

The Federal Reserve, on the other hand, has short-term interest rates staying extremely low despite the fact that they predict rising rates of economic growth, a condition that usually produces higher levels of interest rates.  This is because the demand for money generally increases with the rising level of incomes produced by the economic growth.

The major point is, however, that the CBO has produced a pretty dismal economic forecast. 

The CBO projection has unemployment rates rising to 8.9 percent in the last quarter of this year, up from 8.5 percent in December 2011.   Furthermore, the unemployment rate is expected to rise to 9.2 percent in the final quarter of 2013. 

This is not good!

And, what happens to the amount of under-employment if the CBO forecast takes place.  We certainly would see the under-employment rate stay in the 20 to 25 percent range.

On top of this is the real threat of recession in Europe.  The question is, how much does a European recession play into the forecasts of the Congressional Budget Office?

My big fear has been that a recession in Europe will have very negative connotations for growth in the United States.  (See my post, “Issue Number 1 for 2012: Recession in Europe,” http://seekingalpha.com/article/317268-issue-number-1-for-2012-recession-in-europe.)

Data released yesterday and presented by the Financial Times indicates that the unemployment rate for the eurozone was at 10.4 percent at the end of 2011 for the whole workforce, and was at 21.3 percent for the category “youth.”  Furthermore, the consensus real GDP growth for the eurozone is at negative 0.3 percent, not a level that is conducive to the reduction in the unemployment rate. 

The unemployment rate ranges from 22.9 percent in Spain and 19.2 percent in Greece to 5.5 percent in Germany and 4.1 percent in Austria showing the split that exists within the eurozone, itself. (See ”Eurozone Jobless Rate at Euro-era High,” http://www.ft.com/intl/cms/s/0/dca5fe48-4bf3-11e1-98dd-00144feabdc0.html#axzz1l92ForcZ, and, “Contraction Threat Clouds Euro Zone,” http://professional.wsj.com/article/SB10001424052970204740904577194442237686180.html?mod=ITP_pageone_3&mg=reno-secaucus-wsj.)

How much impact will this “European Recession” have on the economy of the United States and has it really been taken into account by the forecasters of the CBO and the Federal Reserve System?

And, given the over-extended position of consumers (http://seekingalpha.com/article/328252-where-is-the-u-s-consumer), corporations (http://seekingalpha.com/article/326412-corporate-confidence-continues-to-wane) , and banks (http://seekingalpha.com/article/320698-what-s-to-like-about-the-united-states-banking-system), where might a pickup in spending take place?

Given these facts, I tend to agree more with the economic projections of the Congressional Budget Office than I do with those of the Federal Reserve.  However, if we do achieve the growth rates of the Congressional Budget Office it would seem that the cumulative federal deficit for the next five years would be closer to the cumulative federal budget deficit of the past five years…in excess of $6 trillion, than what is now being forecast.

In essence…we are going nowhere…fast!

Mr. Bernanke Gets His Way

Well, Mr. Bernanke has moved the Federal Reserve to a position of greater transparency. 

We now have projections of interest rates out until the end of 2014.  It is now believed by most members of the Fed’s Open Market that the Federal Funds rate will remain close to zero until the end of 2014.

What is the probability that the Federal Funds rate will be close to zero for the last six months of 2014?

In my mind, zero or close to it!

What is the probability that the Federal Funds rate will be close to zero for the first six months of 2014?

In my mind, zero or close to it!

What is the probability that the Federal Funds rate will be close to zero for the last six months of 2014?

You guessed it!

And, so on…

Seems like I don’t have a lot of confidence in these forecasts. 

What are these forecasts for, then?

I have already written my answer to this question.  These forecasts are to make Mr. Bernanke feel better. (http://seekingalpha.com/article/317453-bernanke-transparent-about-his-lack-of-self-confidence)

Mr. Bernanke doesn’t want to be misunderstood.  Apparently, in the past, Mr. Bernanke feels that he has been misunderstood.  Now, with the “new transparency” there should be no doubt where Mr. Bernanke and the Fed stand…and Mr. Bernanke should feel justified.

This is the first time in my mind that the Federal Reserve has done something of this magnitude so as to make the Chairman of the Board of Governors feel better.

I hope it achieves its goal because as far as I am concerned this new transparency program does absolutely nothing for me in terms of understanding where interest rates are going to be for the next two to three years.  It does absolutely nothing for me in terms of understanding what the monetary policy of the Federal Reserve is going to be for the next two to three years. 

If anything this new transparency program will assist, in the shorter-term, speculators in making lots of money.  George Soros, and others like him, loves a situation in which a government says it is going to maintain a price for as long as it can.  This type of government activity creates “sure thing” bets. 

The economy is in the condition it is in because there is still a lot of insolvency around.  By keeping short-term interest rates as low as they are helps financial institutions and other private or public organizations remain open hoping that they will be able to work themselves out of their insolvency. 

According to a report released Wednesday put together by the American Bankers Association and State Bankers Associations, thirty percent of the commercial banks reporting were under some form of written agreement with regulators.  A total of 1000 banks responded to the survey, so the study should be fairly representative.  Extrapolating this to the total number of banks in the banking system we would get some 1,900 banks under some kind of agreement with the regulators.   

This is when there are still some 864 commercial banks on the FDIC’s list of problem banks, which we know does not include all the banks under some kind of agreement with the FDIC. 

Many home owners still find the market values of their homes below the amount of the mortgage that exists on the property.  Commercial real estate loans are still defaulting at a very rapid pace and many businesses are declaring bankruptcy or are near filing for bankruptcy, especially small ones.

It is understood that the Federal Reserve must continue to protect against further economic deterioration and must continue to protect those individuals and institutions that are insolvent or near insolvency. 

Because of this and the consequent slow pace of economic growth the Fed must continue to keep the economy excessively liquid.

I don’t know that publishing interest rate forecasts for the next three years will convince us any more that the Fed is attempting to protect the banking system and the economy.  I guess it must help Mr. Bernanke to sleep better to know that he is releasing all this information even if it does little or nothing for anyone else.           

What the Federal Reserve is Risking

There are two articles in the Wall Street Journal today that I believe are very important responses to the announcement of the Federal Reserve that it will release interest rate projections for several years out.

The first of these by Kelly Evans says a mouthful: “Boosting Transparency, Fed Puts Its Reputation on the Line.” (http://professional.wsj.com/article/SB10001424052970204331304577141034029100316.html?mod=ITP_moneyandinvesting_5&mg=reno-secaucus-wsj) 

I love the quote that Evans leads the article with…it is from Abraham Lincoln: “it is better to remain silent and be thought a fool than to open one’s mouth and remove all doubt.”

First of all, to produce projections of interest rates three years into the future?  Come on…

And, to release the forecasts from all 17 members of the Federal Reserve’s open-market committee…

This is to produce credibility?

Come on…

Furthermore, the projections are to “make monetary policy more effective by lowering volatility and uncertainty in the market around the path of future rates.” 

Formerly, those in the Federal Reserve believed that some uncertainty should surround its goals because this allowed markets to move incrementally due to the fact that market participants had to search for where the Fed was moving.  At least this was the way it was when I worked at the Fed.

Knowing what the target will be results in markets that take discrete leaps…up or down…as market participants jump to the place where the wizards at the Fed now presume interest rates should be.

But, two points on this.  The first one is that making everything depend on the Fed’s prognostications and the persistence with which the Fed holds onto the projections, can lead to “sure-thing” bets on the part of market participants.  There are plenty of examples around in which “the market” bets against the ability of a government or a central bank to hold onto a desired “goal”.  As the pressure builds up, the probability that the government or central bank will have to adjust to the reality of the situation can approach 100 percent. 

The second point is that the Federal Reserve may actually be the cause of the volatility and uncertainty it is attempting to reduce.  As the very actions of the Fed become less recognizable and as, as Evans states, the forecasts “differ significantly from reality” the authority of the Fed decreases and this, in itself, creates “volatility and uncertainty.”

I would argue very strongly that the actions of the Federal Reserve over the past four years…if not longer…have been a large part of the uncertainty it abhors and this has resulted in the increase in market volatility that it would like to reduce.  But, this increase has not been due to a lack of “transparency” on the part of the Fed but has been due to a lack of understanding on the part of the Fed.   And, this lack of understanding has been transmitted from the Fed to the financial markets.     

This is where the other article in the Journal comes in: “Fed Rate Outlook to Bite Traders.” (http://professional.wsj.com/article/SB10001424052970203471004577141182345031606.html?mod=ITP_moneyandinvesting_3&mg=reno-secaucus-wsj) In this piece, Cynthia Lin argues that “With its push to provide a clearer policy road map, the Federal Reserve is about to give bond traders one less reason to like medium-term bonds as it pins down yields that already are at historic lows.”

Ms. Lin quotes Kent Engelke, chief economic strategist at Capitol Securities Management as saying, “The short end of the (yield) curve is dead.” 

Ms. Lin goes on, “Some investors even are suggesting that the new policy may give little reason to trade bonds maturing as late as 2019.”

Doesn’t someone at the Fed understand this possibility?

I have always assumed that volatility was a function of the depth and breadth of the market.  If the policy of the Fed has the result that it will tend to reduce the number of traders in the market, then it would seem to me that this is a movement will have the wrong consequences for the market.

As I stated yesterday, I believe that the move made by Mr. Bernanke and the Fed to achieve greater “transparency” of Federal Reserve operations is more an effort to justify what Mr. Bernanke and the Fed have done over the past four years or so. (See “Bernanke “Transparent about his lack of self-confidence,” http://seekingalpha.com/article/317453-bernanke-transparent-about-his-lack-of-self-confidence.) 

Furthermore, I believe that what has been done to the Fed over the past decade has changed central banking in the United States more that we can possibly imagine at this time.  And, as most of you know that have read my blog over the past, almost four years, I am not convinced that the movement has been in the right direction.  Unfortunately, I believe that we will be paying for this movement, in one way or another, over the next four or five years.       

Bernanke "Transparent" About His Lack of Self-Confidence

This post is about the Fed’s latest effort to build confidence in the financial system by “providing the predictions of its senior officials about their own decision, hoping to increase its influence over economic activity by guiding investor expectations.” (http://www.nytimes.com/2012/01/04/business/economy/fed-to-start-publicly-forecasting-its-rate-actions.html?_r=1&ref=business)

“The inaugural forecast will show the range of predictions made by Fed officials about the level of short-term interest rates in the fourth quarter of 2012, 2013, and 2014….  It will also summarize when they expect to start raising short-term rates….”

To me, this is Ben Bernanke’s latest effort to justify himself and what he has done.  It is Mr. Bernanke’s cry to financial markets: “please understand me.”

But, the more Mr. Bernanke cries for understanding, the more he digs a hole for himself with respect to the future.  For one, who can believe that anyone can forecast short-term interest rates for a three-month period let alone for a three-year time frame?  The record of the people at the Fed is no better than that any other group of forecasters. 

Second, by telegraphing the Fed’s intention, the Fed will be setting itself up for financial markets to “bet” against it.  This is always a possibility when central banks or governments explicitly state their policy goals.  And, the “bet” many times can become a “sure thing.”  Perhaps the best, most recent example of this is the Soros “bet” against the British government in the 1990s about the value of the pound. 

Ultimately, to me, this effort at “transparency” is a sign of Mr. Bernanke’s real lack of self-confidence in his ability to lead the Federal Reserve through this difficult time.  He can’t understand why people don’t understand what he is doing and so he tries, harder and harder, to create this understanding.  His steps to gain greater “transparency” over the past six months is just evidence of his struggle.        

I will admit that I am not, nor have I ever been, a fan of Ben Bernanke as the Chairman of the Board of Governors of the Federal Reserve System.  I was in favor of him being the Chair of the Economics Department at Princeton University…but not Chair of he Fed. 

I was against Bernanke’s re-appointment as the Chairman (http://seekingalpha.com/article/151474-exit-strategy-an-argument-against-bernanke-s-reappointment) and disappointed in President Obama for actually re-appointing him (http://seekingalpha.com/article/158762-bernanke-s-disappointing-reappointment).

In reviewing Bernanke’s record since being a member of the Board of Governors, I see nothing but a competent academic, out of his element and over-his-head in the deep water of a twenty-first century whirlpool. 

In more peaceful times when he was just a member of the Board of Governors (August 5, 2002 – June 21, 2005) he was a lackey of the then Fed Chairman Alan Greenspan, developing the argument for Greenspan’s defense of recent monetary policy that used the savings of China and the Middle East to finance U. S. Treasury debt. 

He was a strong supporter of Greenspan’s effort to keep the Federal Funds rate at one percent in the 2003-2004 period to combat the possibility of the economy going into a deep recession.  This effort helped to underwrite the “bubble” that took place at this time in the U. S. housing market. 

Then, once he was became Chairman of the Federal Reserve on February 1, 2006, he was a firm advocate of pushing the target rate for the Federal Funds rate to 5.25 percent and keeping it there into August of 2007 so as to combat the possibility that inflation might get out-of-hand.  

The Fed move was in response to the financial market meltdown of “Quant” financial firms that took place in August 2007. (See book review on “The Quants”, http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson.)

The recession in the United States began in December 2007.

The next episode of Bernanke’s “steady hand on the tiller” came in the fall of 2008.  I have characterized Bernanke’s reaction to the Lehman Brothers failure as one of panic.  (See my post “The Bailout Plan: Did Bernanke Panic”, http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

But, what Bernanke and the Fed did next has been the basis for the claim that Mr. Bernanke saved the United States from a second Great Depression.  The Federal Reserve acted to increase its balance sheet from slightly less than $900 billion is assets to more that $2.0 trillion in assets by the beginning of 2009.  Through various stages of Quantitative Easing (QE), the Fed’s total assets now amount to more than $2.8 trillion.

This injection of funds into the banking system has resulted in around $1.6 trillion in excess reserves on the balance sheets of U. S. banks.  It has created little in the way of bank lending or economic growth.    

However, many people have given credit to Mr. Bernanke for saving the country and this may be an appropriate gesture on the part of a grateful country.  My concern has been that this policy is nothing more than a policy of throwing sufficient “stuff” against the wall to see what would stick.  As a consequence, monetary policy in the United States has become a tool of ignorance, not of professional competence. 

And, that is exactly where we are today.  That is why there is so little confidence in the Chairman of the Federal Reserve System in world financial markets.

Thus, that is why the Chairman of the Federal Reserve System is struggling to reach out to the financial markets to justify what he has done…and is doing.

This effort, in my mind, will achieve little or nothing…and could do much harm.

Recent Monetary Policy and the Growth of the M1 Money Stock

Since the end of June 2011, excess reserves held by commercial banks have declined by about $107 billion. (Remember in August 2008 when excess reserves in the banking system totaled only $2.0 billion…for the whole banking system!) For the two-week period ending November 30, 2011, excess reserves averaged almost $1.6 trillion.

Reserves balances held at Federal Reserve banks dropped by about $110 billion over the same period of time. On December 7, 2011, reserve balances were slightly under $1.6 trillion.

Excess reserves held by the banking system and reserve balances at the Federal Reserve tend to move in the same direction and in about the same magnitude.  The reason for focusing on reserve balances held at Federal Reserve banks is that this number comes from the Fed’s balance sheet and can be related the movements of line items that appear on the balance sheet.

This decline in reserve balances has not been overtly driven by Federal Reserve actions.  In fact, three factors have dominated this decline, and each of the three is independent of what the Federal Reserve might be overtly doing. 

The first two factors relate to components of the Federal Reserve’s portfolio of securities.  After the Fed’s holdings of U. S. Treasury securities, the largest part of the portfolio is made up of mortgage-backed securities.  From the end of June through the current banking week, the amount of mortgage-backed securities on the Fed’s balance sheet dropped by $82 billion and represented maturing securities. 

The Fed’s holdings of Federal Agency securities also feel by almost $11 billion during this same time period again from the run-off of maturing issues. 

The third factor that helped to decrease reserve balances was a $31 billion increase in currency in circulation outside the banking system.  That is, when currency is drawn out of the banks and moves into the hands of individuals, families, and businesses, bank reserves go down…unless these outflows are offset by other actions of the Federal Reserve. 

Just these three factors alone resulted in a $124 billion reduction in bank reserves.  Some open market operations as well as other operating factors offset this decline, but the net result, as mentioned above, was that overall excess reserves in the banking system decline by more about $110 billion over this time period.

While these excess reserves were declining, however, we observed during the same time period, a sizeable change in the speed at which the money stock was growing.  For example, in June, the year-over-year rate of growth of the M1 measure of the money stock was about 6 percent.  In July, the rate of growth increased to 16 percent, in August it was slightly more than 20 percent where it has stayed. 

The M2 measure of the money stock did not show such dramatic increases, since the M1 measure is a subset of the larger total, but it, too, increased during this time period.  In June, the year-over-year rate of growth of the M1 measure was about 6 percent.  In July the growth rate of this measure rose to 8 percent and then jumped to 10 percent in August where it has remained. 

In July and August, the banking system experienced huge gains in demand deposits while in June, July, and August savings deposits at depository institutions rose dramatically. 

These movements along with the continued strong demand for currency in circulation can still be used as evidence that the economy remains very weak.  The $31 billion increase of currency in circulation mentioned above has resulted in the currency component of the money stock measure showing a year-over-year rate of growth by the end of October of almost 9 percent, which is a very high figure historically.  

The movements taking place in the money stock figures point to the weak economy in two ways.  First, with people under-employed, with people trying to stay away from debt, and with businesses trying to build up large stashes of cash, the demand for currency and for transaction balances at financial institutions rises.  Weak economies cause economic units to keep more of their wealth in a form that is readily accessible and spendable.

The second piece of evidence, however, is the extremely low interest rates associated with the weak economy.  With interest rate so low, it just does not pay for people to keep funds in interest-bearing accounts. Over the past five months, savings deposits at financial institutions have dropped by almost $75 billion and funds kept in institutional money funds have dropped by $160 billion over the same time period.  A large portion of these funds has apparently gone into currency and transaction balances.   

People are still getting out of short-term assets and placing their funds, more and more, in transactions-type accounts.  This is a sign of the weak economy and not of economic growth or a successful monetary policy. 

This is “debt deflation” type of behavior. (http://seekingalpha.com/article/307261-debt-deflation-is-it-a-possibility) It is a type of behavior that the Federal Reserve has not yet been able to over come. And, having the Fed toss more “stuff” against the wall does not seem to be the policy to turn things around.

Federal Reserve officials keep talking about up the fact that they have not run out of things that they can do to continue to try and stimulate the economy.  Unfortunately, it seems to me that fewer and fewer people are listening to their pleading. 

With a banking system that is still much weaker than the authorities are willing to talk about; with a consumer sector and business sector that, for the most part, are still trying to reduce their debt load; and with a public sector that is sorely out-of-balance and doesn’t seem to know where it wants to go; people are confused and uncertain about their future and about what to do.  

In this kind of environment, people want to hold onto what they have and want to avoid as much risk as they can.  They don’t want to borrow if they don’t have to and they want their assets to be as liquid as possible.

This is what the Federal Reserve is facing. 

A Leading Indicator: Corporate Stock Buy-Backs

I must admit to being wrong.  I believed that the big cash buildup at corporations would be used to fuel a mergers and acquisitions binge.  I thought that the economic recovery was strong enough that the “better off” corporations would “pick off” all the low-hanging fruit offered by the companies that were not in a very good position coming out of the Great Recession. 

I argued that this behavior would not accelerate economic recovery because the restructuring taking place would result in consolidations and debt reductions that would just make industry more productive somewhere down the line but add very little to economic growth and lower unemployment in the present.

Merger activity has been fairly high this past year but not as great as I thought it would be.    

Where I was wrong…was in the strength of the recovery.  The economic recovery is not strong enough to propel the M&A binge I expected. 

So, what are the cash accumulations and the low borrowing rates leading to? 

Corporations buying back their own stock.

“US companies are on pace to announce buy-backs of more than $500 billion worth of shares this year, according to stock research firm Birinyi Associates, the third biggest year on record.” (http://www.ft.com/intl/cms/s/0/546f97ec-1231-11e1-9d4d-00144feabdc0.html#axzz1fwprkyNi)

The message is that the economy is not recovering sufficiently to warrant more acquisitions and the stock markets have not been robust enough to provide higher valuations for market shares, so, the companies with the cash or with access to the cash are buying back their stock at prices they believe to be ridiculously low. 

This can have some consequences for firms.  For example, Safeway, Inc., sold $800 million in bonds last week and, the same day, management disclosed that it was buying back $1 billion worth of its own common shares. 

The rating agency, Fitch Ratings, immediately dropped the company’s credit rating by one notch to triple B minus. 

A similar thing happened to Amgen and Lowe’s.  Last month, Amgen sold $6 billion worth of bonds to buy back its stock early in November…and Moody’s Investors Service cut Amgen’s bond rating by one notch while Fitch cut its rating by two notches.  Lowe’s sold bonds in November to buy back stock, which resulted in downgrades by Moody’s and Standard & Poor’s. 

That is, the debt issue followed by the stock buy back increased the financial leverage of these companies and hence make their debt riskier.

Stock buy backs, however, do not increase economic growth!

What is happening?

Long-term interest rates in the United States are being kept down by the actions of the Federal Reserve and the flight of money from Europe seeking a “safe haven” in United State Treasury bonds.  The Fed wants to get the economy going again and has said it will keep rates at historically low levels for another two years or so.  And, “with corporate bonds benchmarked to US Treasuries, whose yields have fallen to historic lows amid strong demand for havens, borrowing costs fro investment grade companies have also fallen.”

So what do we have…low economic growth and credit growth that exceeds the “productive” needs of the corporations. 

In essence this is a picture of credit inflation.  To be sure, we are not seeing the creation of credit raising consumer or wholesale prices at this stage…but, when credit expansion exceeds the real growth rate of the economic sector that the funds are going into we get a “dislocation” that can lead to problems in the future.

That is why, to me, the acceleration of corporate stock buy-backs in this instance seems to me to be a leading indicator of dislocations in the economy that will have to be dealt with at a later time.

“Although bondholders generally do not like these transactions (issuing bonds to buy back stock) because of the risk they pose to companies’ credit ratings, most of the groups buying back shares this year with debt have not seen too much fall-out from the bond markets or from credit rating agencies.”

This is always the case.  Those that move first and move rapidly get the most benefits from their actions.  Only later, when many others attempt the same thing, do markets…and credit rating agencies…move more…or produce greater “fall-out.”

“The deals, then, are likely to continue so long as investors keep buying bonds and pressuring rates.”

And, as the Fed works to keep interest rates so low.

The concern about corporate stock buy-backs being a leading indicator?

If economic growth does not pick up a greater speed (http://seekingalpha.com/article/312223-the-focus-should-be-on-underemployment-not-unemployment) and if the Fed continues to maintain the excess reserves it has pumped into the banking system and keep interest as low as it has promised to do, then we need to be aware of where the dislocations are forming in the economy. 

And, be assured, if this credit inflation begins to show up in some places…it will also begin to show up in other places as time passes.  That is, fault lines are created in the economy much as Raghuram Rajan has described in his award winning book called “Fault Lines: How Hidden Fractures Still Threaten the World Economy.”  And, fault lines make everything more fragile.   

Central Banks in Liquidity Action...Not Solvency Action

Here we go again!

The central banks acted yesterday and the markets went wild!  Six central banks acted in concert to make sure that European banks…and others…could get dollars if they wanted them.

This is a liquidity action!

It is an act to keep the flow of short-term funds flowing in world financial markets…just as these six central banks did after the Lehman Brothers failure. 

Once again, the definition of a liquidity crisis is that there is a short term need for “buyers” in a market because, for the short term, the “buyers” that are usually there are not there.  The “sellers” want to sell assets and obtain dollars.

“Buyers” without dollars are not what is wanted.  So the central banks are making sure that there are plenty of dollars available so that the “sellers” can sell their assets.

The emphasis, however, should be on the short-term nature of a “liquidity” crisis. 

The fundamental problem is still the solvency problem facing several of the sovereign nations of Europe. (See my post from yesterday, “European Debt Must Be Restructured,” http://seekingalpha.com/article/310994-european-sovereign-debt-must-be-restructured.)

Providing liquidity to the market will not resolve the solvency problem.  As almost everyone except the officials in Europe know, the efforts of the last two years or so to treat European debt problems as a “liquidity” issue has resulted in the situation we now find ourselves in. 

As in the past, central bank action has gotten a favorable response from stock markets around the world.  In the past, the quick, dramatic response to the central bank action has been followed by a retreat.  If nothing is done on the sovereign debt restructuring need, the stock markets will, in all likelihood, retreat once again.

The word out is that this liquidity action on the part of the central banks gives the officials in Europe some time to deal with the restructuring. 

But, the restructuring is also only a short-term response for eventually the eurozone must deal with the whole question of how the fiscal affairs of the eurozone will be handled.  The concern is that restructuring of the debt without reforming how the nations of the eurozone discipline their fiscal affairs just creates a situation in which fiscal irresponsibility can survive into the future.

Revising how the eurozone conducts its fiscal affairs, however, cannot be done overnight.  Yet, the financial markets must be given some kind of credible assurances that fiscal discipline will be forthcoming before they will really settle down. 

This seems to be the unknown…for the single currency framework will not last without the eurozone achieving some kind of fiscal unity.  Is this what Germany is holding out for?

So, is the problem going to be resolved now…or, are we just going through another cycle?

I still am not convinced that the Europeans, at this stage, possess the backbone to do what is necessary!

Oh, and once all these dollars get out into world markets…will they be withdrawn once the “liquidity” crisis is over?

Big Banks Get Bigger While the Smaller Banks Disappear

The FDIC released data on the state of the banking industry last week.  And, we see that the size and number of the bigger banks increase while the size and number of the smaller banks continue to decline.

Let’s look at the number of banks in the United States first.  The number of banks in the United States dropped by 61 from June 30 to November 30 leaving only 6,352 banks still in existence.  Note that the FDIC closed only 26 banks in the third quarter of 2011.

Over the past 12 months, the number of banks in the banking system dropped by 271 banks. 

Obviously, if we focus on just the number of banks that the FDIC closed, we are not getting the whole picture as many unhealthy banks that might eventually be closed are being acquired.

The number of banks on the FDIC’s list of problem banks dropped to 844 on September 30, down from 865 on June 30.  So, the number of banks on the problem list dropped by 21, the number of failed banks was 26, and the number of banks leaving the banking system was 61.  Seems like more banks went on the problem list than left it in the third quarter of the year.  Maybe the statistics on problem banks is not as "jolly" as indicated. 

Over the past 12 months, however, the largest bank classification, banks with assets in excess of one billion dollars rose by 10.  Banks with less that $100 million in assets declined by 176 over the past year and banks with assets between $100 million and $1.0 billion dropped by 105.

Whereas the average size of banks in these last two categories remained about the same over the past year, the average size of banks over $1.0 billion in rose by $1.5 billion to $22.0 billion.

At the end of September 2011, there were 2,208 banks that were less than $100 million in asset size and these banks represented about 1.0 percent of the assets in the banking industry.  On the same date, there were 3,626 banks with assets ranging from $100 million to 1.0 billion, and all of these banks just controlled slightly more than 8.0 percent of the assets in the banking industry.

There were 518 banks in the United States that had assets in excess of $1.0 billion, and these 518 banks controlled 91.0 percent of the assets in the banking industry.

In terms of loans, Net Loans and Leases at the smaller commercial banks declined by almost $8.0 million over the past year, by $2.5 million over the past quarter.  The Net Loans and Leases at the middle range of banks dropped by a little less that $50.0 million over the past year and by about $4.0 million over the past quarter.

In the larger banks, Net Loans and Leases increased by more than $70.0 million over the past year and by about $36 million over the past quarter. 

The bottom line is that commercial banks with assets totaling less than $1.0 billion continue to produce statistics that cause one to question the health of this segment of the banking industry.  In addition, given the decline in total assets in these banks, the sector has not observed a consistent reduction in noncurrent assets (past due loans).  That is, there has only been a modest reduction in the average amount of noncurrent assets to total assets over this time period. 

Consequently, the larger banks are getting larger and becoming more dominant all the time.  And, if one looks at Federal Reserve statistics, the largest 25 domestically chartered banks in the country control about two-thirds of all the assets held by domestically chartered banks.  Thus, if the largest 518 banks in the country control 91.0 percent of the banking assets, this means that 493 banks that are larger than $1.0 billion in asset size but are not among the 25 largest, control about 24 percent of the assets. 

All the statistics show that the small- to medium-sized banks are really becoming insignificant in the United States banking industry and, given the troubles that many of these banks still face, will become even less significant in the future. 

An article in the Monday edition of the Wall Street Journal presents research showing that the health of the banking industry is being questioned by the stock markets.  Andrew Atkeson and William Simon write that “The recent volatility in bank stocks is a signal that U. S. banks, large and small, are not as healthy as many analysts assume.” (http://professional.wsj.com/article/SB10001424052970204531404577052493270860130.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj)

“The dynamic has played out twice before over the past 85 years—in the Great Depression and the panic of 2008-09—with devastating consequences for the broader economy.  Over the past three months, investor uncertainty about the soundness of bank balance sheets, manifested in the daily volatility of stock prices is back up to levels seen historically only in advance of these two great crises.”

“This extraordinary volatility is not limited to the stocks of large banks but extend to small and midsize banks as well.”

So much has been written about the condition of the banking industry in Europe.  Very little has really been written about the condition of the banking industry in the United States.  Investors in the stock market seem to have picked up this concern.

And, I have argued for more than two years now that the major reason that the Federal Reserve has pumped so much money into the banking system is that the United States banking industry has severe problems.  And, the fact that banks have held onto these funds as excess reserves and have not loaned them out is an indication of the fact that many of the banks are still not solvent.  However, the fact that the Fed has provided so many excess reserves to the banking system has allowed the FDIC to either close banks or approve acquisitions of weak banks as smoothly as possible.  The Fed and the FDIC have, so far, prevented any panic from occurring. 

However, problems remain.