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?

Making the Same Mistakes All Over Again

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

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

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

In another article, Scott Minerd, chief investment office at Guggenheim Partners, argues that “There will Be More Monetary Elixir After the End of QE2”: http://www.ft.com/intl/cms/s/0/96ec2b02-8146-11e0-9360-00144feabdc0.html#axzz1Mnj4kmN5. 

The motivation for QE3? “The same motivation for QE1 and QE2: namely, stimulating growth to help employment recover…Looking ahead, the expiration of tax cuts in 2011 and a government deficit reduction program will present real headwinds to growth.  Layer on top of that the fact that 2012-13 would probably be the end of the expansionary portion of the business cycle, and what is left is a recipe for a serious economic slowdown or possibly even another recession.”

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

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

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

That is, the United States government will lose its unlimited privilege to flood the world with debt and liquidity at little or no consequence to itself.

  

All three of these articles are concerned with the view that the basic problems of the economy have to do with liquidity…and not solvency.

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

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

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

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

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

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

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

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

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

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

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

It's A Solvency Problem, Not A Liquidity Problem!

Discussion is swirling around the Fed’s new quantitative easing program, QE2.

The wisest comment I have heard up to this point about the QE2 exercise is the quote attributed to the economist Allan Meltzer at a recent celebration on Jekyll Island, Georgia commemorating the clandestine meetings that resulted in the creation of the Federal Reserve System 100 years ago.

Mr. Meltzer is quoted as saying, “There isn’t a liquidity problem.” (http://www.nytimes.com/2010/11/08/business/economy/08fed.html?ref=business)

But, one of the problems of this whole exercise is that almost the whole effort to reverse the financial meltdown and the economic slowdown has been attributed to the fact that many of our governmental leaders, Mr. Geithner and Mr. Bernanke, have seen the crisis as a “liquidity” problem. That is, to the problem that financial institutions can’t sell their assets.

And, these leaders continue to assess the situation as a “liquidity” problem. Some of us, however, see the continuing problem as a “solvency” issue. There is a world of difference between the two.

The original response of the government to the financial crisis was to create a program, the Troubled Asset Relief Program (TARP), which would allow the Treasury “to purchase illiquid, difficult-to-value assets from banks and other financial institutions.” This was enacted by Congress on October 3, 2008.

On October 14, 2008, Secretary of the Treasury Paulson and President Bush announced the first revisions to the program. Without going into the revisions more deeply, the Treasury announced their intention to buy senior preferred stock and warrants in the nine largest American banks. For there on, the effort “to purchase illiquid, difficult-to-value assets” all but completely disappeared.

Yet, the leadership in Washington, D. C. continued to speak as if the whole financial crisis was just a “liquidity crisis”.

I have addressed this issue many times before in my writings. But, let me use the words of Richard Bookstaber in his book “Demon of Our Own Design”: “A liquidity crisis is generally related to financial institutions and not to nonfinancial institutions. This is because financial institutions have assets on their balance sheets that have ‘liquidity’. The very ability to liquidate is at the root of the liquidity crisis.”

In a liquidity crisis there is the problem of “asymmetric information”. This problem occurs where one party to a potential transaction has all or most of the information about the value of an asset and other parties do not have the same information.

A liquidity event is most often set off with a shock to the market. In the case of Long Term Capital Management, an arbitrage situation was interrupted by a default by Russia on outstanding bonds. In the case of the Penn Central Crisis, the Penn Central railroad company declared bankruptcy when it had been thought to be a going concern. The buy-side of the market goes away because investors have little or no information.

Exacerbating this situation, Bookstaber states, is the fact that, very often, market participants can identify the seller that MUST sell its assets and this means that the buy side can be even more selective as to when buyers want to enter the market or not. In the recent problem experienced by the French bank, Society General, the market knew who was having problems and that they had to sell a substantial amount of assets to unwind certain transactions on their books.

In many cases associated with a liquidity crisis, without the intervention of the central bank, there is no reason for buyers to re-enter the market until more information becomes available to them. The bottom line to this analysis is that a “liquidity crisis” is a short term affair that requires immediate central bank action. Funds must be made available to the financial markets so that market participants can feel and believe that a “bottom” is reached in terms of the decline in asset values. This is where the Federal Reserves’ “Lender of Last Resort” function comes into play.

The “solvency crisis” is not usually such an immediate problem. Solvency issues can play a part in the liquidity crisis (note the longer term outcomes relating to Long Term Capital Management, Bear Stearns, and Lehman Brothers) but the real solvency crisis relates to a longer period of time and has to do with cleaning up balance sheets and raising new capital. It is not just an issue of “liquidating” an asset in the market place. The value of assets can deteriorate either due to changes in market valuations or due to the financial condition of borrowers. It is a question as to the ability of someone to fully repay another.

A solvency crisis is longer term than a liquidity crisis because the financial institutions need to proceed in an orderly way to work out the situation they face with respect to the value of the assets on their balance sheets. But, this “working out” process may take six months or a year to resolve. The working out of assets requires a substantial amount of time and attention from the managements of financial institutions. Thus, to get back to business as usual requires that a management get the problems behind them so that they can concentrate on what they really should be doing…running a business, not “working out” loans.

If a recession is not to broad or deep then some kind of governmental stimulus can “buy the banks” out of their solvency problems by means of inflation. If the problems have existed for some period of time and are also connected with too much risk taking and excessive amounts of financial leverage, the problems may not be so easily overcome. And, in these latter cases, fiscal and monetary stimulus may not be able to accomplish much in helping financial institutions “get back to business.” Inflation doesn’t help a lot.

How, then, should we interpret the current “crisis”? Well, do you believe that our main problem is still “liquidity” or is our main problem “solvency”?

For those that read this blog regularly, they know that I believe that the “liquidity crisis” occurred a long time ago, in the fall of 2008. I believe that we have been dealing with a “solvency” crisis since then. And, I believe that we are still going through this “solvency” crisis.

If you look at my post of November 8, 2010 you can see that I believe that the “solvency” crisis still has a ways to run. (http://seekingalpha.com/article/235487-the-banking-system-seems-to-be-dividing-large-vs-small-commercial-banks) If you believe as I do that we are still in the midst of a solvency crisis then you also should believe that further additional fiscal or monetary stimulus will have little or no effect on the banking system or the economy. Financial institutions are still “working out” their bad assets and they will not really want to return to “business-as-usual” until they can devote their full attention to making loans.

It is a hard thing to do to run a financial institution. I have been involved in the running of three of them. In order to be successful you need to give your complete attention to running the business and not to “working out loans” which is very demanding and very time consuming. A “liquidity crisis” does not draw this kind of long-time attention.

The State of the Recession--a long way to go

Going into this holiday weekend, we need to take a little time to reflect on the state of the economy and the financial markets. I certainly don’t want what I write below to sound like a “rosy scenario” but I would like to try and put some perspective on where I think we are and what is ahead of us.

First, as I have written many times, the liquidity problem is behind us. Liquidity problems are of short term nature and require immediate action. The difficulties we now face are related to solvency and the ability to work things through. This takes time and it takes persistence, things that Americans are often impatient with.

My argument here is that many of the problems we face are known. In the words of the world famous philosopher Donald Rumsfeld, in dealing with a “solvency problem” we are dealing with “known unknowns.” (To clarify my argument, I would argue that a “liquidity crisis” is related to “unknown unknowns.”) Banks and other financial institutions, along with non-financial organizations, unless they are just blinding themselves to the truth of the situation, know what they need to watch out for. That is one reason why banks are not lending much these days. (See my post “The Clogged Banking System” http://seekingalpha.com/article/129838-the-clogged-banking-system.)

The “solvency problems” has to do with assets whose value is less than that recorded on the balance sheet of an organization. This “solvency problem” has been exacerbated by the large amounts of debt financial institutions and others have used to acquire these assets thereby leaving the problem of whether or not the equity base of the company exceeds the “hole” that exists between the “real” value of the assets and the value recorded on the financial statements.

The “unknown” here is exactly how much the organizations will eventually get from the “known” questionable assets. The answer to this hinges upon the issue of whether or not the value of the asset will improve if these organizations work with the asset, especially if the asset is a loan that the borrower has some chance of repaying in large part. The alternative, of course is that the value of the asset will never increase and needs to be “charged off” right now.

There is no question that banks and other financial institutions tend to be overly optimistic about their ability to “work things out”, but this is a time when they need to be as realistic as possible about the condition their assets are in. This is a turnaround environment and having led three (successful) bank turnarounds I know how important it is to be realistic about asset values at a time like this. Good leaders, good executives, are ones that face the problem head on and do not try and postpone the inevitable.

But, there is a second issue here. The government help that has been provided to the private sector has not always been helpful. If fact, some of the actions of our leaders have created an environment of greater uncertainty, something that an uncertain economy and financial system does not really need. For example, those of you that have read my posts over time know that I am very skeptical of the actions taken last fall by the Chairman of the Federal Reserve System. (See my post on “The Bailout Plan: Did Bernanke Panic?” http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

The follow up to this was the execution of the bailout plan, fondly labeled TARP. It was obvious that our leaders were making up the plan as they administered it which led to several changes in direction that totally confused participants and the market. Plus there was never any oversight administered to the program so the money went out and no one knew where it went.

Now we have a “recovery package” that has been approved by Congress. Again, there is great uncertainty about what the “package” is and what will it do. (See my posts
http://seekingalpha.com/article/117878-the-obama-stimulus-plan-why-i-m-concerned and
http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan.)

Then, following this package we had the “summary” of a bank toxic asset program presented by Secretary Geithner that bombed and then the presentation of the P-PIP (See my post http://seekingalpha.com/article/127639-public-private-investment-program-liquidity-or-solvency.) which Nobel prize-winning economist Joe Stiglitz and others have torn into as providing a fantastic “real option” that provides tremendous upside for private investors and horrendous potential downsides for tax payers. Furthermore, in response to criticisms that this opportunity was just for “big” players, the Treasury responded that, well, smaller organizations would be let into the game—and, well, we may let the individual investor get into the scheme just like the patriotic program that allowed individuals to buy Treasury bonds during World War II.

The third issue centers on the amount of debt outstanding in the world. We write about the plight of the United States consumer and all the debt that he/she accumulated during the credit bubble of the early 2000s. This is a problem and will take a long time to work itself out with layoffs and unemployment increasing and bankruptcies, both individual and small business, on the upswing, along with rising delinquencies on credit cards and other consumer loans and with the overhang of large amounts of residential mortgages repricing over the next 15 months or so. This will be a drag on the United States economy for a while.

Real investment in the economy will not begin to rise until consumers get their balance sheets in order and feel confident enough to spend once again. However, many analysts are arguing that the economy is in for a structural shift, returning the United States consumer to a more fiscally conservative balance sheet with more of their disposable incomes going toward saving. This will require businesses to be smaller and more conservative in their operations. Both will retard recovery.

In addition, there is the problem of debt in the world. There are huge amounts of debt outstanding in the world that are going to have to be dealt with over then next three years of so. (An example of this looming problem is discussed in the Financial Times this morning, “Eastern Eggshells,” http://www.ft.com/cms/s/0/f3f00a48-249c-11de-9a01-00144feabdc0.html.) This just points to the fact that this recession is world wide in nature and the fate of the United States is going to be tied up with what goes on in Eastern Europe, in Japan, in China, in Russia, in Western Europe, and so on and so on.

This is why a growing number of people, like Niall Ferguson, author of “The Ascent of Money” is concerned that the United States—and others—are trying to resolve the problems created by too much debt and financial leverage by increasing the amount of debt and financial leverage that is in the world. These people are contending that we are all in this together and we must fight extreme national self-interest and protectionism.

The state of the nation is precarious—there is no doubt about that. However, I believe that we have progressed to the point that we are dealing with “known unknowns” rather than “unknown unknowns”. There is still much uncertainty in the economy, in the world, and people are attempting to work through the problems they face. But, because there are many people feeling a lot of pain right now and there will be more joining their ranks in the near future, there is a great deal of pressure to do a lot of “something” about it. And, in the minds of many, the effort must err on the side of doing too much rather than in doing too little. The potential downside to all these efforts is that much of what will be done may actually create more difficulties than they solve. Impatience is not always a virtue.

The State of the Bailout

Treasury Secretary Paulson gave a press conference yesterday and indicated that things had changed…that the focus of the bailout effort would not be on the purchase of ‘toxic assets’ but would be aimed to assist the capital needs of financial institutions and consumer finance. This ‘shift’ in focus has been duly noted by the press.

Is the ‘bailout’ program having any success?

To answer this question, I am roughly in the same spot of someone I heard being interviewed on Marketplace on NPR radio: the ‘expert’ was asked the following question “Has the efforts to add liquidity to financial markets and financial institutions shown any results to date?” His reply: “I think things are better than they would have been if the efforts had not been made.”

Does that give you a lot of confidence?

I just don’t think that at this time anyone can say more. We are in the middle of a situation that no one present has ever been through. Fed Chairman Ben Bernanke, an expert on the Great Depression, has seen to it that financial markets and financial institutions have been flooded with liquidity. From the banking week ending September 10, 2008, Reserve Bank Credit has risen from about $890 billion to $2.1 trillion in the banking week ending November 5, 2008. This is roughly a 210% increase in a matter of 8 weeks. (Dare I remind you that it took 94 years for the total of Reserve Bank Credit to reach just $890 billion and only eight weeks to add $1,167 billion more!)

The $700 billion bailout bill…is now turning into a provision of capital for financial institutions…a provision that the Treasury hopes will buy time for institutions to work out their bad asset problems. The unknown question here is whether or not $700 billion is enough or will Congress have to float more funds.

The underlying rationale for the provision of all this liquidity is that either (1) officials are going to be blamed for allowing another MAJOR economic bust to take place or (2) these officials are going to have a problem cleaning up for all the liquidity that they have supplied to the financial markets on such short notice. Success, in the eyes of the officials means that they will have to clean up all the liquidity once the financial markets begin working again. Failure…”is not an option.”

No one knows at this time what is going to happen…

The idea is to keep tossing more and more liquidity into the pot until financial institutions feel that enough is enough! No one has been here before! This is all new!

Your guess is as good as mine…

And then there is the need for fiscal stimulus. The Congress is going to consider a stimulus package which seems to be similar to the first stimulus package they passed earlier this year. It will be aimed at consumers and, although it may not be any more effective than the first package, it can be done quickly, and it will show that the Congress IS doing something AND any little stimulus to the economy will be appreciated.

But, a second stimulus bill is being talked up. This one would be more capital intensive and aim at real projects like projects to rebuild the United States infrastructure. The idea here is that consumers are not going to start spending much until their job security is enhanced and they are sure that they will hold onto their homes. Businesses are going to have to restructure their balance sheets and have some confidence that consumers are going to start spending again before they loosen their purse strings and begin to invest in capital projects again. We seem to be a long way from either of these so the argument goes that the Government needs to engage in some real “Keynesian” pump-priming. The problem with a Government expenditure program like this is that it takes time to prepare and then, once the bill is passed, it takes time for the projects to be implemented. So, help does not come quickly.

And, what about the stock markets? When are they going to come back? Well, we hear all the time that the price an investor is willing to pay for a stock is dependent upon future cash flows. Right now, market expectations concerning future cash flows are pretty depressed and uncertain. Investors must be able to sense a turnaround in future cash flows for them to develop any confidence to begin purchasing stocks. And, investors don’t really know the value of the assets on the books of a large number of companies. To me, a good argument can still be made for more asset charge offs, more bankruptcies, and more depressed forecasts of future cash flows. In my mind, we are not near the bottom here, particularly given the situation described above.

What about uncertainty?

There is lots of it. Much of the uncertainty pertains to the programs that will be coming out of the new administration and the leadership that is put into place by that administration. It is still a long way until January 20, 2009. The current administration has been reluctant to do anything in the past until it became absolutely necessary to do something about the financial markets and the economy. They still want to pass on as much of the decision making as possible to the newly elected administration. So, we are still in a limbo as far as the national leadership is concerned.

What about the international situation and international leadership?

Also an unknown. People are talking about a new Bretton Woods…the international financial structure set up after the second world war. First off, that conference had two years of preparation and negotiation before the meeting was held. There has basically been little or no preparation for the meetings to take place this weekend. Second, the first Bretton Woods conference had seasoned world leadership behind it. That is not the case at the current time. Third, there is almost no intellectual consensus concerning the cause of the current situation and what should be done about it. Fourth, the world is still going through a economic downturn with more countries declaring every week that they are now in a recession.

International coordination and cooperation are going to have to be vital components of the world economic and financial markets in the future but for right now, I don’t think that we can expect much concrete to be forthcoming from the world community.

So, in my view, we will continue to see a downward drift to stock markets with a substantial amount of volatility. What else is new?

For bond markets, United States government securities are going to continue to be the pick for risk-averse investors and spreads will continue to rise between the least risky debt and that considered to be more risky. I saw that the spread between Baa corporate bonds and Aaa corporate bonds exceeded 300 basis points last week. For even lesser credits the spread has been increasing at an almost exponential rate. If there is any indication that the credit crisis is NOT over, it can be picked up from the market place.

The only thing that seems to be positive news at this time is that the Bush plan to get the price of oil below $60 a barrel has been tremendously successful so far!

The Federal Reserve and the Banking System--Banking Week ending October 22

At the end of the banking week closing on Wednesday September 3, 2008, Federal Reserve Bank credit amounted to $887.3 billion or roughly $0.9 trillion. At the close of the banking week ending Wednesday October 22 Federal Reserve Bank credit totaled $1,803.3 billion or about $1.8 trillion. The increase in Federal Reserve Bank credit rose 103.2% in seven weeks! These figures are from the Federal Reserve release H.4.1, Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.

Reserve balances with Federal Reserve Banks on an average daily balance rose from $10.9 billion in the earlier week to $301.3 billion in the week ending Wednesday October 22. The balances were down to $220.8 billion at the close of business on Wednesday October 22.

In terms of total bank reserves, a figure that also includes vault cash used to satisfy reserve requirements, the increase has been massive. Total bank reserves (on a non-seasonally adjusted basis), averaged $44.2 billion during the two weeks ending September 10, 2008. For the two weeks ending September 24, total bank reserves averaged $111.3 billion! And, for the two weeks ending October 22, total bank reserves averaged $327.6 billion! This is a 641.2% rise in a little more than a month.

The Monetary Base also shows substantial increases. (The Monetary Base consists of all things that are bank reserves or could become bank reserves, like the currency component of the money stock.) In the two weeks ending September 10, 2008, the Monetary Base averaged $849.9 billion. This figure rose to $915.1 billion in the two weeks ending September 24 and then climbed to $1,148.6 billion or about 1.15 trillion in the two weeks ending October 22. This is a rise of 35.2% from the earlier date. This rate is lower than the others because much of the monetary base is made up of currency in circulation which does not change as much over time.

The plan of the Federal Reserve is to liquefy world financial markets as much as possible. The Fed is pushing out the liquidity and it seems as if there is they are finally getting some response.

Money stock growth finally seems to be increasing. The M1 measure of the money stock is showing a rise of 13.0% from the 13 weeks ending July 14 to the 13 weeks ending October 13. The primary growth is coming in both the currency component and the demand deposit component of the money stock. As of yet this movement has not translated itself into the M2 measure of the money stock.

These numbers are no guarantee that the Fed’s efforts are gaining some success, but it does present a little bit of hope…and in today’s financial markets we are looking for all the hope we can find!

The Federal Reserve and the Banking System

At the end of the banking week closing on Wednesday September 3, 2008, Federal Reserve Bank credit amounted to $887.3 billion or roughly $0.9 trillion. At the close of the banking week ending Wednesday October 8, Federal Reserve Bank credit totaled $1,575.6 billion or about $1.6 trillion. The increase in Federal Reserve Bank credit rose 77.6% in five weeks! These figures are from the Federal Reserve release H.4.1, Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.

Reserve balances with Federal Reserve Banks rose from $3.8 billion in the earlier Wednesday to $175.6 billion on Wednesday October 8. (On a daily average basis the figure for the week ending October 9, 2008 was $119.7 billion, up from $10.9 billion for the week ending September 3, 2008, and up from $7.1 billion in the banking week ending October 10, 2007.) Again, these figures are from the Federal Reserve release H.4.1.

In terms of total bank reserves, a figure that also includes vault cash used to satisfy reserve requirements, the increase has been massive. Total bank reserves (on a non-seasonally adjusted basis), averaged $44.2 billion during the two weeks ending September 10, 2008. For the two weeks ending September 24, total bank reserves averaged $111.3 billion! And, for the two weeks ending October 8, total bank reserves averaged $179.5 billion! Using monthly figures, total bank reserves for September 2008 are 243% larger than September 2007!

Wow! I’m breathless!

The Monetary Base also shows substantial increases. (The Monetary Base consists of all things that are bank reserves or could become bank reserves, like the currency component of the money stock.) In the two weeks ending September 10, 2008, the Monetary Base averaged $849.9 billion. This figure rose to $915.1 billion in the two weeks ending September 24 and then climbed to $989.8 in the two weeks ending October 8. The year-over-year increase from September 2007 to September 2008 is 9.9%! (This year-over-year increase is as low as it is because the currency component of the money stock is such a large part of the measure and this figure doesn’t change very much over time. Still, an increase of about 10% is a huge increase!)

The plan of the Federal Reserve is to liquefy world financial markets as much as possible. It is doing its job. The problem seems to be that there is a liquidity trap. (See my post of October 8, 2008, “Caught in a Liquidity Trap”.) The Fed is pushing out the liquidity…but institutions are absorbing the liquidity without pushing it on.

Federal Reserve Operations: The Last Six Months

A lot has changed over the last six months in terms of how the Federal Reserve conducts its operations. We are still learning how to interpret the data that are available to us in order to discern what it is the Federal Reserve is attempting to do…and whether or not it is succeeding. This post represents my attempt to present some analysis as to what has been achieved.

The three major factors occurring over the past six months, the items that have garnered the most press coverage, are the liquidity crises that peaked in March 2008, the dramatic lowering of the Fed’s target Federal Funds rate, and the dramatic rise in the price of oil. Not getting so much press but of equal importance has been the introduction of new Federal Reserve tools such as the Term Auction Facility (TAF) and the Primary Dealer Credit Facility. The conduct of monetary policy has to be put within the context of these events.

In order to try and put everything into context, let me start out be examining the supply and demand for money. Generally in a liquidity crisis there is a sudden increase in the demand for money. The central bank attempts to ease the strain on the money markets by throwing open its lending window, supplying funds to the market in other ways, and maintaining or lowering interest rates. By doing these things the Fed supplies liquidity to the market and facilitates the selling of securities so that banks and other institutions can meet their obligations. Total reserves in the banking system increase.

We know that the Federal Reserve dramatically lowered, in several successive moves, its target for the Federal Funds rate. But, what happened to bank reserves? In January and February of this year, the year-over-year rate of growth of total reserves in the banking system (not seasonally adjusted) was just above zero. In March the year-over-year rate of growth jumped to 4.7%, dropping off to 2.2% and 2.4% in April and May. Obviously, there was some growth in total reserves to help resolve the liquidity pressures in the money markets. (One can note that the year-over-year rate of growth in total reserves for June dropped back to a 0.7% rate of increase.)

So the Fed was supplying reserves during the March-April-May period, but did this have any effect on money stock growth? If we look at the narrow measure of the money stock, M1, we see that its year-over-year growth rate from January through May varied around 0.0%...it didn’t seem to grow at all. However, the broader measure of the money stock, M2, experienced a rise in it’s year-over-year growth rate going from a rate of growth in the fourth quarter of 2007 of about 5.5% to a rate of growth of 6.8% in February 2008, 7.1% in March 2008 before dropping off to 6.5% and 6.4% in April and May, respectively. (One can note that in June the rate of increase had fallen to 6.0%)

One can conclude that during the period of greatest market stress, the Federal Reserve oversaw and increase in the growth rate of total bank reserves that was accompanied by an increase in the growth rate of the M2 money stock. Thus, the Fed underwrote the lowering of its target rate of interest by supplying reserves to the banking system, thereby causing an increase in money stock growth. This is classic central bank behavior.

The question then becomes, how did the Federal Reserve accommodate the problems in the money markets by its operational actions. For this we have to go to the Federal Reserve’s Factors Affecting Reserve Balances, the H.4.1 statistical release. Here is where things get messy. Because of limited space, I am only going to deal with aggregate movements at this time. (If you would like more detail in another post, dates as well as accounts, please let me know.)

From the banking week ending January 2, 2008 through the banking week ending April 2, 2008 the Federal Reserve supplied reserves to the banking system through Repurchase Agreements ($37.8 billion), Other Loans ($39.4 billion) and the Term Auction Facility ($60.0 billion). That is, the Fed supplied the market with $137.2 billion in reserves during the first quarter of the year. But…the Fed’s holdings of securities fell by more than this, removing $156.5 billion in reserves from the banking system. This indicates that the Fed actually allowed reserves to flow out of the banking system during the first quarter of the year…something you would not expect in the period a liquidity crisis was taking place!

What happened? Well on the other side of the sources and uses statement we see that currency in circulation declined by $13.6 billion and other deposits at the Federal Reserve fell by $3.5 billion. These are regular seasonal swings as currency in circulation builds up in the fourth quarter of a year for the holiday season and then declines in the first quarter of the next year as needs for currency are reduced. The swing in other deposits at the Federal Reserve has to do with Treasury deposits and relates to tax dates. So, factors supplying reserves declined by $16.3 billion (incorporating other minor changes in accounts) while factors absorbing funds declined by $15.6 billion (incorporating other minor changes in accounts). Therefore, reserve balances at Federal Reserve banks actually fell during the first quarter of 2008.

But, as indicated above, the growth rate of total bank reserves actually increased throughout the quarter. How can this be explained? Well, the decline in reserve balances actually decreased less this year than it did last year and so total reserves increased, resulting in a year-over-year increase in the rate of growth of total reserves. The Federal Reserve actually eased the pressure on the money markets while seeing reserve balances at the Fed fall. Ah, the problems of these technical factors!

Interpretation…the Fed got $60.0 billion to the banks that needed reserves through the TAF…and a further $39.4 billion to the market through its lending facility. In the first quarter, the major increase in Fed lending came through the Primary Dealer Credit Facility, the borrowing window available to dealers in securities. The Fed continued to supply needed liquidity to the money markets through Repurchase Agreements. Basically, these efforts got funds to the organizations that needed them and did not force them into selling securities at losses…both good results.

In the second quarter, the Fed directly supplied reserves to the banking system and continued to support the year-over-year growth in total bank reserves but not at the peak rate through March 2008. The Fed’s holdings of securities continued to decline, falling $110.2 during the quarter. Also, Fed lending declined by $28.4 billion in the second quarter as both banks and securities dealers repaid borrowings. These declines were partially offset by an increase of $50.0 billion of TAF funds and an increase of $32.8 billion in Repurchase Agreements. There were new factors supplying reserves to the banking system during this time. Other Federal Reserve Assets increased by $40.9 billion. This increase was due to the drawing down of the Fed’s Currency Swap line established with the European Central Bank, the Bank of Switzerland, and other central banks. In additions, the Fed supplied $29.8 billion in reserves related to the Bear Stearns bailout. (This appears in a line item labeled “Net portfolio holdings of Maiden Lane LLC”.) Factors supplying reserves to the banking system netted out to a +$14.5 billion. Factors absorbing reserves during the second quarter netted out to +$13.1 billion (the largest factor absorbing reserves was the seasonal increase in Currency in Circulation which increased by $11.1 billion.) Taking much of the seasonal swing out of the change in total reserves resulted in a decline in the year-over-year rate of growth of total reserves, dropping to just a 0.7% increase by June.

The conclusion: the Federal Reserve seems to have gotten through the period of the credit crisis in good shape. The crucial thing is that it lubricated the market when if was in the greatest need of liquidity and then seemed to back off as the money markets stabilized. The bottom line to this is that the Fed seems to have backed off in continuing to supply liquidity after the liquidity crisis abated. I would argue that money stock growth (M2) is still too high and under the present circumstances points to a rate of inflation of around 4% per year, but the central bank had to deal with the liquidity crisis first before it could move on to other objectives. I must add, however, that we are just getting used to the new tools and institutional arrangements and so any analysis must be tentative.

Markets and Uncertainty

This is not the best time to be recommending books to people. But, I thought that, given all the turmoil around, it would be worthwhile for us to remember some relatively recent works that might help us to regain some perspective on markets (financial and otherwise) and guide us back to the fundamental issues we have to deal with during times like these. It is all too easy to get caught up in personalities or specific situations and that, in my mind, is exactly what we don’t want to do. For example, Paul Krugman’s Op-ed piece in the New York Times on March 10, 2008, is an example of emotional reporting and needs to be tempered with a review of the basics on which market participants need to concentrate: http://www.nytimes.com/2008/03/10/opinion/10krugman.html?hp.

I have great admiration for former Treasury Secretary Robert Rubin and have found his book (written with Jacob Weisberg) titled “In An Uncertain World: Tough Choices From Wall Street to Washington (Random House: 2004) to be helpful in the sense that Rubin has apparently systematically applied the techniques of decision making under uncertainty to both business and governmental situations. (I, like a lot of other people, are waiting for his next book in which he will discuss his role in the recent events at Citibank.) In terms of dealing with uncertainty there are two important ‘take-aways’ from this book. The first is that uncertainty in pervasive in human decision making. The thing that differentiates one situation from another is whether greater uncertainty or less uncertainty applies. The second pertains to the methodology used: the decision maker must be try to identify all of the possible outcomes related to the decisions that are available to her or him; and the decision maker must, in some way, assign probabilities to each of the possible outcomes.

Of course, the methodology that Rubin proposes is not an easy one to apply, particularly when one is under stress and is having to deal with markets that can move quite rapidly. Difficulty, however, is no excuse for not attempting, even in a simple way, to deal with the uncertainty that the individual is facing. We must do our research, we must read a lot and listen to many different opinions, and we must then make the best effort we can. There are no objective criteria for determining a comprehensive list of possible outcomes and the probabilities to assign to each outcome: everything is ‘subjective’. Intuition and experience are important factors alongside knowledge and skill.

Another book that is helpful in understanding the process of decision making under conditions of uncertainty is that of Michael J. Mauboussin titled “More Than You Know” (Columbia University Press, Updated Expanded Edition: 2007). There are several ‘take-aways’ from this book that should be remembered in dealing with uncertain markets. One of the first is that people tend to consider too narrow a range of potential outcomes. Thus, it is always relevant for people to expand their perspective and give attention to the possible outcomes they might otherwise exclude. It is a good discipline to force yourself to consider outcomes that you think only have a small probability of occurring. In doing so, you protect yourself from unintentionally eliminating outcomes that you might ordinarily dismiss from careful consideration.

A second thing that Mauboussin discusses which might be important in our analysis of uncertain situations is that all analysts and commentators will not be correct all of the time. Thus, we must not rely on one or just a few individuals for their view of the market. However, we should pay more attention to those analysts and commentators that have a higher ‘batting average’ than others. Even though we know that all will be wrong some of the time, those with a higher’ batting average’ will tend to have more ‘streaks’ of being right and longer ‘streaks’ than those whose ‘batting average’ is much lower. Thus, there are some analysts and commentators we should review more than others even though we know that they will be wrong a fair percentage of the time.

A third relevant factor is that individuals, according to the research that Mauboussin cites, do not always act in a completely rational way. For example, they may weigh possible losses more heavily than gains in their decision making. However, even though individual participants in the market may not be completely rational, if these participants generally act independently of one another, markets will ‘tend’ to be priced appropriately. This is because that, when aggregated into the whole market, the deficiencies of the individual decision makers seem to cancel out and the resulting prices tend to be a relatively adequate reflection of all the information that is available to the market at that time.

The time when this will not be true is when individuals do not behave independently of one another. At these times, the market becomes unbalanced because opinion tends to congregate on the buy side of the market or on the sell side and people act more like a ‘herd’ than independent individual decision makers. These are the times when the markets become ‘disorderly’ and present the greatest problem to policy makers. We have given special names to some of these disorderly situations such as ‘liquidity crisis’ or ‘credit crisis’ or ‘market collapse’.

There are two other books on markets and uncertainty that provide a good deal of insight into the world of decision making under uncertainty. Both of the books are by Nassim Nicholas Taleb: the first of these is titled “Fooled by Randomness” (Random House, 2005); and the second is “The Black Swan: The Impact of the Highly Improbable” (Random House, 2007). Both of these books contribute to our understanding of the point made by Robert Rubin that there are, at most, only a limited number of situations in life that are not subject to uncertainty. Uncertainty comes from not having all the information we need in order to make a decision or to solve a problem. The idea that we have complete information on every situation we face in life is just a fantasy. The tendency to narrow the range of possible outcomes we consider in any specific case is related to our desire for greater certainty in life: humans tend to act as if they had complete information. Taleb presents us with example after example of the absence of complete information in our decision making or problem solving.

One additional fact is emphasized by both Mauboussin and Taleb: the probability distributions that apply to most uncertain market situations are not normal distributions. Although the probability distributions used should all conform to the general rules of probability theory, it has been shown that the tails of these probability distributions are ‘fatter’ than those of a normal distribution. That is, extreme events should have more probability assigned to them than would be the case if the probability distributions were normally constructed. Thus, these extreme events may not be very probable, but the expected impact of their occurring can be more substantial than might be thought. This conclusion is not meant to frighten, but only to serve as one more piece of information that will help us to understand the performance of the markets in which we operate.

Recently in a talk, Federal Reserve Governor Fred Mishkin indicated how uncertainty can impact price relationships within a market. The case that Mishkin discussed related to the calculation of inflationary expectations measured by the difference between the yield on the10-year Treasury bond and the yield on the 10-year inflation protected Treasury securities, TIPS. This differential has been increasing since the first of the year and the general interpretation given the increase is that financial market participants now expect more inflation over the next 10 years than they had expected last fall. Mishkin argued that the increase in this differential was not due to an increase in inflationary expectations but was due to an increase in the ‘uncertainty’ of what inflation will be. In this respect, uncertainty can affect markets. But, we must deal with uncertainty as analytically as possible, for that is the best way to make decisions because it tempers the impact of the more dramatic events that we generally see in the headlines.

The Fed: A new operating tool--the TAF--and a Liquidity Crisis

The February 11 post reviewed the operations of the Federal Reserve in 2007. The analysis stopped short of the full year because of the innovations that the Fed introduced in December. This post picks up the story. On December 12, 2007, the Federal Reserve announced, along with the Bank of Canada, the Bank of England, the European Central Bank (ECB), and the Swiss National Bank (SNB) “measures designed to address elevated pressures in short-term funding markets.” The actions taken by the Federal Reserve included the establishment of a temporary Term Auction Facility (TAF) and the establishment of foreign exchange swap lines with the European Central Bank and the Swiss National Bank. Under the TAF program, the Federal Reserve auctions term funds to depository institutions against a broader range of collateral than under normal open market operations. The effort is to “help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress.” In effect, the Federal Reserve used the TAF to supply reserves to the banking system for terms of roughly one month while reserving the use of its standard tools— repurchase agreements and reverse repurchase agreements—for shorter term reserve adjustments. The temporary reciprocal currency arrangements with the ECB and the SNB will provide dollars for these organizations to use for supplying liquidity within their jurisdictions. The swap lines were approved by the Federal Open Market Committee of the Federal Reserve System for up to six months.

One can observe the use of these facilities on the Federal Reserve release H.4.1, Factors Affecting Reserve Balances of Depository Institutions. The Federal Reserve release can be obtained from the website of the Federal Reserve under “Economic Research and Data” and then “Statistical Releases and Historical Data.” There is a new line item on this release called TERM AUCTION CREDIT: an increase in Term Auction Credit supplies reserves to the banking system. The information on the swap lines is a little more difficult to come by…it is aggregated in the line item labeled OTHER FEDERAL RESERVE ASSETS. The only thing one can say about this line item is that it usually does not change very much. The swap transactions with the ECB and the SNB are usually relatively large and hence can be estimated by the magnitude of the changes in Other Federal Reserve Assets. An increase in Other Federal Reserve Assets supplies reserves to the banking system.

Now, let’s review Federal Reserve actions for the period that includes December 2007 through the most recent statistical releases. I will divide this period up into the time before the banking week ending January 23, 2008, the banking week ending January 23, and the time period after this. The crucial date in all of this is January 21, 2008 which is the day that information became available about the $7.2 billion write-off to be taken by a French bank due to the actions of one of its traders. This knowledge and the fact that the bank was trying to sell off the positions established by this trader led to a ‘liquidity crises’ in world security markets. The next morning the Federal Reserve announced that it was lowering its target Federal Funds rate by 75 basis points, an extraordinary amount. But, let’s go back to early December.

Up through the banking week ending January 16, 2008, two factors dominate the statistics. First, there is the normal Christmas season/end-of-year swing in various items that are a part of the Fed’s basic operations. Currency in circulation always increases in the holiday season and then declines right after the first of the year. This season was no exception and was handled in the usual way. Second, however, there was the introduction of the TAF. The first auction settled on December 20 and was for $20.0 billion; the second auction settled on December 27 and it, also, was for $20.0 billion. These can be seen clearly on the H.4.1 for the banking weeks ending December 26 and January 2. One can also notice from these releases that OTHER FEDERAL RESERVE ASSETS increase by $14.3 billion and $11.2 billion, respectively. We assume that these increases reflect the use of the swap lines set up with the ECB and the SNB. The Federal Reserve offset these increases by allowing parts of its Treasury bill portfolio to mature without being replaced ($29.0 billion) along with a decline in repurchase agreements ($16.0 billion). Roughly, the Federal Reserve added $65.5 billion in reserves to the banking system through the new measures announced on December 12, 2007, and allowed $45.0 billion in securities to run off which reduce reserves in the banking system. The difference between the two offset other factors influencing bank reserves with nothing else out-of-the-ordinary occurring. Thus, the initial implementation of the new facilities seemed to go ahead without any disruption to the financial markets.

World financial markets dropped precipitously on Monday, January 21, a day which fell into the banking week ending January 23. On that Monday afternoon members of the FOMC got together by phone and voted to reduce the Fed’s target Federal Funds rate by 75 basis points. The Fed had already injected the third round of TAF funds into the banking system on January 17 in the amount of $30.0 billion, $20.0 to replace those funds maturing from the first auction plus an additional $10.0 billion. The financial markets stabilized: the only market comment being on the size of the reduction of the target rate. In terms of the statistical data, even with all the turmoil in the world markets, there was very little movement in the Fed’s major operating areas.

Three important things events took place in the next three banking weeks. First, at the January 29 meeting of the FOMC, the committee lowered the target Federal Funds rate another 50 basis points, bringing the total reduction to 125 basis points in ten days. This was huge, historically! Second, the Fed held another auction on January 28 for $30.0 billion, $20.0 to replace the funds maturing from the second auction and another $10.0 million in new auction funds. Third, in the banking week ending January 30, the Fed put about $8.0 billion of reserves into the banking system by means of repurchase agreements. These were allowed to expire in the banking week ending February 6 along with another $3.3 billion of repurchase agreements that expired in the banking week ending February 13. One can assume that these repurchase agreements had provided liquidity to help settle the market turmoil mentioned above and as the disruption receded the Fed just allowed these positions to unwind.

The market sell-off on January 21 represented a true liquidity crisis. Here a banking organization HAD to sell securities. The bank was identified and the market realized that A LOT of securities had to be sold. As has been described in earlier posts, this meets the definition of a liquidity crisis where the question becomes, “Where should market prices be?” Until the market is able to answer this question sellers in the market tend to outnumber buyers and prices continue to fall. The classic response of the central bank is to provide liquidity to the marketplace. And that is what the Federal Reserve did.

Operationally, the Federal Reserve seems to have acted quite well during this whole period. It handled the normal seasonal swings without any trouble. It also proceeded with the transition to the TAF and the swap agreement without difficulty. Basically, the Fed put $60.0 billion in Term Auction Funds into the banking system while allowing $65.0 in it holdings of US Treasury securities to mature without replacement. Finally, here we are four weeks after the ‘liquidity scare’ and markets are functioning without problems. Yes, there are still solvency problems that must be resolved, but that is another story, a longer-term story. One can argue that the Fed’s actions in January and beyond helped to short-circuit the liquidity crisis which is exactly what a central bank is supposed to do.

People in the financial markets, as well as analysts, still have some questions about the leadership of the Fed. Many market participants feel that last fall there was a disconnect between what the Fed said and what the Fed eventually did. Also, the substantial drop in the target interest rate raised a flag about the stability of Fed decision making. Concerns like these contribute to a lack of complete confidence in the abilities of those currently guiding the Fed. Public officials, until their credibility is proven, always face confidence issues early on in their tenure.