Although analysts have detected “Green Shoots” in the economy signaling the possibility that there may be a recovery occurring sometime soon, it is my belief that we will need to see some signs of life in the banking system before we can get too excited about any sustainable upswing. Right now, I don’t see any “Green Shoots” in the area of commercial banking.
The only indication that something might be starting to happen in the banking sector is the apparent “credit thaw” in the money markets. An article in the Wall Street Journal touts the “voracious demand for short-term debt issued by U. S. and European banks.” We are told by one New York trader that “bank commercial paper ‘flies off the screen.” (See “Credit Thaw Is Spurring Appetite for Bank IOUs” at http://online.wsj.com/article/SB124890956451491803.html#mod=todays_us_money_and_investing.) The London interbank offer rate has dropped and relative interest rate spreads have fallen indicating that confidence is returning to this sector of the money market.
Yet commercial banks are not lending. They are not lending to each other and they are not lending to businesses. Commercial banks are still reducing their own debt or just holding onto the cash! The only lending that seems to be happening is on pre-approved home equity loans and on pre-approved credit card balances and other revolving consumer credit. Year-over-year, the change in total commercial bank lending and leases is roughly zero.
In terms of banks lending to other banks, from June last year to June this year, the decline in Fed Funds lending and reverse repurchase agreements with other banks has dropped 15%. These loans have dropped another $60 billion in the four week period ending July 15 from a total of $319 billion!
Credit risk is not the reason that the commercial banks are not lending to each other. In normal times, commercial banks lend to each other through the Federal Funds market or through using repurchase agreements in order to manage their reserve positions at the Federal Reserve. However, these are not normal times.
Commercial banks really don’t need to lend to each other in order to manage their reserve positions at the Federal Reserve because they are over-whelming liquid!
Note that in the two weeks ending July 15, the Federal Reserve reported that excess reserves in the banking system totaled $743.9 billion dollars! This is up from $1.9 billion in July 2008. Commercial banks have no concerns with meeting their reserve requirements because they are holding reserves at Federal Reserve banks that are far in excess of what is required. And, why should there be any trading of Federal Funds when there are such excesses within the system.
The commercial banking system is recording cash assets, as of July 15, 2009, of $958.7 billion which is up from $320.0 billion in the month of June 2008.
Right now, the lending market seems to be compressed on both sides of the market, supply as well as demand. Not only do banks seem to be reluctant to make loans, there seem to be a dearth of borrowers at this time.
The argument on the supply side is that commercial banks still have two major concerns on their minds. The first is the value of assets on their balance sheets. In terms of asset values, there still is the problem of mortgage foreclosures. We are starting a period of re-pricing of Alt-A and Option mortgages at a time when unemployment impacts are growing. Next year there is apparently another round of re-pricings of subprime mortgages. Credit card losses continue to rise. And, there are still big problems expected in commercial real estate loans. This says nothing about the securitized loans that are still on the books of the banks. The second concern of the banks is who to lend to if they were to make loans. Given the uncertainties with respect to the strength of the recovery and the state of the labor market commercial bank lending practice has reverted to the principles of the “good old days” which begin with “don’t lend to anybody that needs to borrow.”
The demand for loans is tepid at best. De-leveraging and saving are the primary focus of a large portion of the business and family population. Small businesses and individuals are scared enough that they are shrinking their needs for outside funding and are looking more and more to greater self-reliance. Experts in the field don’t see this new behavior pattern changing soon. More larger firms that possess some degree of financial strength seem to be moving to take advantage of the economic distress of others and so they are borrowing more, but not from the commercial banks.
The consequence of this? Commercial and industrial loans at commercial banks have declined by more than $120 billion this year. Consumer loans have declined by $30 billion since February 2009. Real estate loans have remained roughly constant this year.
There is still one more factor that is weighing on the minds of commercial bankers. The Federal Reserve has created a situation in which commercial banks have ended up with well over $700 billion in excess reserves. The question on the minds of commercial bankers is when and how will the Federal Reserve remove these excess funds?
It is obvious from his testimony in front of Congress last week that Chairman Bernanke does not have an “exit strategy” for the Federal Reserve to remove these reserves from the banking system.
My question to you is, “Would you lend out these reserves if you had no idea when the central bank was going to take them away from you?” I certainly would not! I think any banker that wanted to put these excess reserves to work under the current leadership of the Federal Reserve would be foolish!
There may be indications that money markets are warming to the commercial banking sector and this is good. However, this is not putting money out into the economy. We need to keep looking at the commercial banking sector to see when lending starts to pick up. Until it does, consumers and businesses will just have to rely on their own resources to finance a recovery. This does not bode well for a rapid turnaround.
Thursday, July 30, 2009
Tuesday, July 28, 2009
Does Economics Work?
Does economics work?
A lot of people seem to be questioning the validity of economics these days.
My answer to this question is an emphatic yes! Economics does work!
It is only when we forget the basic principles of economics that we get into trouble. In recent years we have forgotten some of those principles and this has resulted in the economic chaos that we find ourselves in today. I would like to concentrate on just three of these principles for I believe that in forgetting these we have created a lot of our own unhappiness.
The first principle relates to what can be called the “value proposition”. Basically in economics it is argued that value or wealth is created when economic units produce goods or services that provide people with utility. That is, unless the economic unit that is producing something adds value to the resources used in the production of those goods and services, people will not purchase them and wealth will not be created.
Innovation is very important to this process because innovation creates new value in developing something new that people come to want. Where there is not a lot of competition in a particular market because the good or service being produced is new or where firms can achieve what is called competitive advantage, the rate of return on invested capital can exceed the opportunity cost of the capital used to produce those goods and services. In other words, under circumstances like these, firms can find projects or investments that have a positive net present value. Wealth is created in such situations.
But, economic units respond to incentives and when other economic units discover an area where the rates of return on invested capital exceed the opportunity cost of raising capital, they will be attracted to enter that market. And, unless there are barriers to entry in entering that market or some other economic factor or government license, patent, or regulation preventing that entry, competition will increase and this will drive down the excess of return on capital over the cost of capital. In the process, more and more goods are produced at lower prices.
Thus, the creation of wealth in society has to do with the fact that economic units must produce goods and services that are of value to others within the society. This is the value proposition.
The second principle is the “no arbitrage” principle. This principle has to do with trading goods or trading financial instruments. Trading occurs when the prices of an asset or of similar assets differ in different markets. The different markets might relate to different geographic areas, to different time zones, to different countries, to any situation in which there might occur a difference in the price of a good. These differences occur because of transaction costs, incomplete information, lack of computing power, and so on.
The “no arbitrage” principle essentially argues that trading opportunities such as these will attract investors seeking to take advantage of the price differentials and through trading to profit from these differentials the differences will go to zero or will be reduced to a spread related to transaction costs. That is, the incentive to profit through arbitrage trading will be eliminated or reduced over time. In other words, the expected value of arbitrage trading is zero. It is a zero-sum game.
There are two things that must be remembered with respect to trading. First, as more and more people discover the price discrepancies in different markets the potential gains from such trading are reduced. As these potential gains decline, traders may attempt to maintain rates of return on such trades by working with riskier assets, by mismatching the maturities of the arbitrage transactions with the funds used to achieve the position, or by increasing the amount of leverage they use. History is clear that as the potential returns to trading decline, traders take on more and more risk in an effort to enhance their performance. Research indicates that the big winners in trading are those that discover the discrepancies before anyone else does.
Second, the whole basis for this kind of arbitrage transaction is that the prices of the assets in different markets move in the opposite direction. This is obvious in a common assumption of arbitrage trading called “reversion to the mean.” In this case, the price of the asset in one market is above the mean price and the price of the asset in another market is below the mean price. The arbitrager is betting that over time the price of the asset above the mean will fall and the price of the asset below the mean will rise and money will be made.
The problem comes when these two prices move in the same direction! Unless the arbitrager is able to continue to finance his/her position over a long period of time he/she will have to take a loss, possibly a substantial loss. Keynes argued that arbitragers will find that they cannot maintain their financing over a sufficiently long period to keep up such an arbitrage position. This is, of course, what happened to Long Term Capital Management.
The third principle is related to the creation of money and credit. The basic idea here is that the creation of money and credit cannot exceed the creation of the real goods and services being produced by a society. In other words, when the growth of money and credit in a society or, in a particular sector of the economy, exceeds the growth rate of the economy or the growth at which goods and services can be produced in a particular sector, prices can become inflated. In terms of the general economy, inflation can occur. In terms of particular sectors of the economy, like housing or companies, asset bubbles can occur. In either case, economic dislocations result that, if the inflation or asset bubble continues, a correction will eventually have to take place. This correction results in a slowdown in economic growth, either in the economy as a whole or in a particular sector, as economic units get their balances sheets back in order with the use of much less debt. That is, credit inflations are followed by debt deflations.
One further complicating factor is that during credit inflations, like those described in the previous paragraph, the economy usually shifts from the emphasis on the value proposition to emphasis on trading. This only exacerbates the dislocations that occur in the economy and makes any correction just that much broader and deeper. Trading, in these situations, is not the basis of a robust economy; creating value is. A correction restores the balance between value creation and trading.
Yes economics works! These three principles are still in place. And, my guess is that they will remain in place for many more years. We only forget them to our own harm!
A lot of people seem to be questioning the validity of economics these days.
My answer to this question is an emphatic yes! Economics does work!
It is only when we forget the basic principles of economics that we get into trouble. In recent years we have forgotten some of those principles and this has resulted in the economic chaos that we find ourselves in today. I would like to concentrate on just three of these principles for I believe that in forgetting these we have created a lot of our own unhappiness.
The first principle relates to what can be called the “value proposition”. Basically in economics it is argued that value or wealth is created when economic units produce goods or services that provide people with utility. That is, unless the economic unit that is producing something adds value to the resources used in the production of those goods and services, people will not purchase them and wealth will not be created.
Innovation is very important to this process because innovation creates new value in developing something new that people come to want. Where there is not a lot of competition in a particular market because the good or service being produced is new or where firms can achieve what is called competitive advantage, the rate of return on invested capital can exceed the opportunity cost of the capital used to produce those goods and services. In other words, under circumstances like these, firms can find projects or investments that have a positive net present value. Wealth is created in such situations.
But, economic units respond to incentives and when other economic units discover an area where the rates of return on invested capital exceed the opportunity cost of raising capital, they will be attracted to enter that market. And, unless there are barriers to entry in entering that market or some other economic factor or government license, patent, or regulation preventing that entry, competition will increase and this will drive down the excess of return on capital over the cost of capital. In the process, more and more goods are produced at lower prices.
Thus, the creation of wealth in society has to do with the fact that economic units must produce goods and services that are of value to others within the society. This is the value proposition.
The second principle is the “no arbitrage” principle. This principle has to do with trading goods or trading financial instruments. Trading occurs when the prices of an asset or of similar assets differ in different markets. The different markets might relate to different geographic areas, to different time zones, to different countries, to any situation in which there might occur a difference in the price of a good. These differences occur because of transaction costs, incomplete information, lack of computing power, and so on.
The “no arbitrage” principle essentially argues that trading opportunities such as these will attract investors seeking to take advantage of the price differentials and through trading to profit from these differentials the differences will go to zero or will be reduced to a spread related to transaction costs. That is, the incentive to profit through arbitrage trading will be eliminated or reduced over time. In other words, the expected value of arbitrage trading is zero. It is a zero-sum game.
There are two things that must be remembered with respect to trading. First, as more and more people discover the price discrepancies in different markets the potential gains from such trading are reduced. As these potential gains decline, traders may attempt to maintain rates of return on such trades by working with riskier assets, by mismatching the maturities of the arbitrage transactions with the funds used to achieve the position, or by increasing the amount of leverage they use. History is clear that as the potential returns to trading decline, traders take on more and more risk in an effort to enhance their performance. Research indicates that the big winners in trading are those that discover the discrepancies before anyone else does.
Second, the whole basis for this kind of arbitrage transaction is that the prices of the assets in different markets move in the opposite direction. This is obvious in a common assumption of arbitrage trading called “reversion to the mean.” In this case, the price of the asset in one market is above the mean price and the price of the asset in another market is below the mean price. The arbitrager is betting that over time the price of the asset above the mean will fall and the price of the asset below the mean will rise and money will be made.
The problem comes when these two prices move in the same direction! Unless the arbitrager is able to continue to finance his/her position over a long period of time he/she will have to take a loss, possibly a substantial loss. Keynes argued that arbitragers will find that they cannot maintain their financing over a sufficiently long period to keep up such an arbitrage position. This is, of course, what happened to Long Term Capital Management.
The third principle is related to the creation of money and credit. The basic idea here is that the creation of money and credit cannot exceed the creation of the real goods and services being produced by a society. In other words, when the growth of money and credit in a society or, in a particular sector of the economy, exceeds the growth rate of the economy or the growth at which goods and services can be produced in a particular sector, prices can become inflated. In terms of the general economy, inflation can occur. In terms of particular sectors of the economy, like housing or companies, asset bubbles can occur. In either case, economic dislocations result that, if the inflation or asset bubble continues, a correction will eventually have to take place. This correction results in a slowdown in economic growth, either in the economy as a whole or in a particular sector, as economic units get their balances sheets back in order with the use of much less debt. That is, credit inflations are followed by debt deflations.
One further complicating factor is that during credit inflations, like those described in the previous paragraph, the economy usually shifts from the emphasis on the value proposition to emphasis on trading. This only exacerbates the dislocations that occur in the economy and makes any correction just that much broader and deeper. Trading, in these situations, is not the basis of a robust economy; creating value is. A correction restores the balance between value creation and trading.
Yes economics works! These three principles are still in place. And, my guess is that they will remain in place for many more years. We only forget them to our own harm!
Sunday, July 26, 2009
The Future of Monetary Policy: The Exit Strategy
The recession seems to be ending. However, many people do not feel that the recovery will be very robust. (See my post “Is the Recession Over?” http://maseportfolio.blogspot.com.)
The crucial claim in the near term though is that the recession seems to be ending.
Because of this the issue that seems on the minds of many people is: how is the Fed going to remove all the bank reserves it has pumped into the banking system over the past ten months? The obvious concern is that the recessionary downdraft would turn into an inflationary nightmare. In other words, these people are asking for an explanation of the “exit strategy” the Federal Reserve plans from its policy of preventing a major economic collapse?
Chairman Bernanke spoke to Congress last week to give some assurance that the Federal Reserve knew what it was doing and would, therefore, do what it needed to do as the economy recovered to keep country from experiencing a wicked bout of inflation. I did not sense a lot of confidence that the hypothesized “exit strategy” would unfold as Bernanke stated that it would.
Bernanke also claimed that the United States economy, although it would begin recovering from the recession soon, would not emerge rapidly. Consequently, the Federal Reserve would have to keep its target Federal Funds rate at the present levels for an extended period of time.
There are two immediate concerns with Bernanke’s presentation. First, the Federal Reserve always tends to react to the economic situation. It does not lead economic events. Simply put, the Federal Reserve will not move in advance of any evidence that inflation is picking up. It will follow such evidence. Furthermore, can you see this Federal Reserve taking on Congress by saying that it is tightening up on monetary policy when economic growth is still moderate or just tepid and unemployment rates are above 8% and inflation has not began to accelerate? This Fed does not have that independence from the political side of the government.
Second, even if inflation does begin to pick up speed increasing rapidly enough to cause some concern in financial markets, can you see Congress accepting an inflation target versus a target for faster economic growth. At no time in post-World War II history has the Federal Reserve crossed a presidential administration or a Congress in the early stages of an economic recovery to follow an anti-inflationary period. This starts right with the “Accord” of 1951 to the present. (The Volcker reign at the Fed does not qualify for this as its timing in the economic cycle was not the same.) The Employment Act of 1948, and as modified, still rules as far as Presidents and Congresses are concerned.
Plus there is the concern over the federal deficit. There will be some form of health care coming along, and an energy policy, and other policy initiatives that will continue to put pressure on the budget of the government. The prospect for further large deficits and a rapidly growing national debt is still a reality that must be faced in the next few years. How is the Federal Reserve going to stay independent of all the Government bonds that are going to be coming to market?
This kind of environment will also encourage private borrowing again, both from businesses as well as the consumer. This kind of environment is inflationary like the early 2000s even if price indices like the Consumer Price Index do not rise dramatically. With private debt soaring along with the debt of the government we will have another period of “credit inflation.”
When the growth of credit exceeds the possible real growth of the economy or if the growth of credit in a particular sector of the economy exceeds the possible real growth of that sector, there is a “credit inflation.” This “credit inflation” can result in an asset bubble as occurred in the housing market earlier this decade where asset prices rose even if “flow” prices, like rents, or, implied rents as estimated for the Consumer Price Index, do not reflect this inflation. In addition, it can result in a substantial deficit in the trade balance and lead to a massive flow of dollars into world financial markets and whether these imbalances in the United States trade deficit will find happy recipients of the dollars, as China gladly seemed to receive dollars earlier on, is a question no one can answer at this time.
There is too much debt already in the financial system and it needs to be reduced. The Fed is trying to do the best it can and I don’t question the “good intentions” of the people that are attempting to get us through this mess. However, the problems are huge and I am not convinced that having good intentions is sufficient to lead us through these times. There is plenty of evidence that there is plenty of pain ahead of us. I am not convinced that Ben Bernanke is the person to create this pain and then lead us through the restructuring of the economy.
The Reappointment of Ben Bernanke to the Chair
There are two reasons I am not in favor of re-appointing Ben Bernanke as Chairman of the Board of Governors of the Federal Reserve System. First, I don’t believe that Bernanke has a plan on how to move the country into the future and I don’t believe that he ever did have a plan to move the country into the future. He was an advocate of “inflation targeting” and a student of the Great Depression. It is not the right time in history to pursue “inflation targeting” and the only thing Bernanke learned from the Great Depression is that if you are going to do something to try and combat a major economic downturn, do it in sufficient magnitude so that no one can say that you erred on the side of doing too little effort.
Second, I believe that the economy is going to have to go through some pain in the near future, a pain that results from the problems related to having too much debt in the economy. To restructure the balance sheets of American finance and industry there are still tough times to go through. I don’t see Ben Bernanke as the inflictor of pain. Paul Volcker was capable of acting in that way and had the personal strength of character to carry it through. Bernanke, in my mind, has neither the ability to inflict discipline on the economy nor does he have the weight of personality to carry it through.
Let’s look at Bernanke’s history. He was complicit with the Greenspan easy money policy that kept interest rates at historically low rates for too long a period of time and created the “credit inflation” that resulted in the housing bubble, the dramatic decline in the value of the United States dollar by about 40%, and the massive flooding of dollars into the world economy. He had no feeling at all for the lending practices in the mortgage sector or for the mess that was evolving in the area of credit derivatives and banking governance. Later on, he continued to follow a policy of fighting inflation when the financial markets were beginning to fall apart. He seemed to react hastily in September 2008 and was not a consistent guide through the bailout of Fannie Mae and Freddie Mac, the collapse of Lehman Brothers, and the strange subsidization of AIG. (See my post of November 16, 2008: http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)
I do not know who should replace Bernanke at this time. All I do know is that we have a new administration and a new economic team. Bernanke, I believe, does not have what it takes to get the financial and monetary situation straightened out. I believe that President Obama needs to appoint his own choice as Chairman of the Board of Governors of the Federal Reserve System.
The crucial claim in the near term though is that the recession seems to be ending.
Because of this the issue that seems on the minds of many people is: how is the Fed going to remove all the bank reserves it has pumped into the banking system over the past ten months? The obvious concern is that the recessionary downdraft would turn into an inflationary nightmare. In other words, these people are asking for an explanation of the “exit strategy” the Federal Reserve plans from its policy of preventing a major economic collapse?
Chairman Bernanke spoke to Congress last week to give some assurance that the Federal Reserve knew what it was doing and would, therefore, do what it needed to do as the economy recovered to keep country from experiencing a wicked bout of inflation. I did not sense a lot of confidence that the hypothesized “exit strategy” would unfold as Bernanke stated that it would.
Bernanke also claimed that the United States economy, although it would begin recovering from the recession soon, would not emerge rapidly. Consequently, the Federal Reserve would have to keep its target Federal Funds rate at the present levels for an extended period of time.
There are two immediate concerns with Bernanke’s presentation. First, the Federal Reserve always tends to react to the economic situation. It does not lead economic events. Simply put, the Federal Reserve will not move in advance of any evidence that inflation is picking up. It will follow such evidence. Furthermore, can you see this Federal Reserve taking on Congress by saying that it is tightening up on monetary policy when economic growth is still moderate or just tepid and unemployment rates are above 8% and inflation has not began to accelerate? This Fed does not have that independence from the political side of the government.
Second, even if inflation does begin to pick up speed increasing rapidly enough to cause some concern in financial markets, can you see Congress accepting an inflation target versus a target for faster economic growth. At no time in post-World War II history has the Federal Reserve crossed a presidential administration or a Congress in the early stages of an economic recovery to follow an anti-inflationary period. This starts right with the “Accord” of 1951 to the present. (The Volcker reign at the Fed does not qualify for this as its timing in the economic cycle was not the same.) The Employment Act of 1948, and as modified, still rules as far as Presidents and Congresses are concerned.
Plus there is the concern over the federal deficit. There will be some form of health care coming along, and an energy policy, and other policy initiatives that will continue to put pressure on the budget of the government. The prospect for further large deficits and a rapidly growing national debt is still a reality that must be faced in the next few years. How is the Federal Reserve going to stay independent of all the Government bonds that are going to be coming to market?
This kind of environment will also encourage private borrowing again, both from businesses as well as the consumer. This kind of environment is inflationary like the early 2000s even if price indices like the Consumer Price Index do not rise dramatically. With private debt soaring along with the debt of the government we will have another period of “credit inflation.”
When the growth of credit exceeds the possible real growth of the economy or if the growth of credit in a particular sector of the economy exceeds the possible real growth of that sector, there is a “credit inflation.” This “credit inflation” can result in an asset bubble as occurred in the housing market earlier this decade where asset prices rose even if “flow” prices, like rents, or, implied rents as estimated for the Consumer Price Index, do not reflect this inflation. In addition, it can result in a substantial deficit in the trade balance and lead to a massive flow of dollars into world financial markets and whether these imbalances in the United States trade deficit will find happy recipients of the dollars, as China gladly seemed to receive dollars earlier on, is a question no one can answer at this time.
There is too much debt already in the financial system and it needs to be reduced. The Fed is trying to do the best it can and I don’t question the “good intentions” of the people that are attempting to get us through this mess. However, the problems are huge and I am not convinced that having good intentions is sufficient to lead us through these times. There is plenty of evidence that there is plenty of pain ahead of us. I am not convinced that Ben Bernanke is the person to create this pain and then lead us through the restructuring of the economy.
The Reappointment of Ben Bernanke to the Chair
There are two reasons I am not in favor of re-appointing Ben Bernanke as Chairman of the Board of Governors of the Federal Reserve System. First, I don’t believe that Bernanke has a plan on how to move the country into the future and I don’t believe that he ever did have a plan to move the country into the future. He was an advocate of “inflation targeting” and a student of the Great Depression. It is not the right time in history to pursue “inflation targeting” and the only thing Bernanke learned from the Great Depression is that if you are going to do something to try and combat a major economic downturn, do it in sufficient magnitude so that no one can say that you erred on the side of doing too little effort.
Second, I believe that the economy is going to have to go through some pain in the near future, a pain that results from the problems related to having too much debt in the economy. To restructure the balance sheets of American finance and industry there are still tough times to go through. I don’t see Ben Bernanke as the inflictor of pain. Paul Volcker was capable of acting in that way and had the personal strength of character to carry it through. Bernanke, in my mind, has neither the ability to inflict discipline on the economy nor does he have the weight of personality to carry it through.
Let’s look at Bernanke’s history. He was complicit with the Greenspan easy money policy that kept interest rates at historically low rates for too long a period of time and created the “credit inflation” that resulted in the housing bubble, the dramatic decline in the value of the United States dollar by about 40%, and the massive flooding of dollars into the world economy. He had no feeling at all for the lending practices in the mortgage sector or for the mess that was evolving in the area of credit derivatives and banking governance. Later on, he continued to follow a policy of fighting inflation when the financial markets were beginning to fall apart. He seemed to react hastily in September 2008 and was not a consistent guide through the bailout of Fannie Mae and Freddie Mac, the collapse of Lehman Brothers, and the strange subsidization of AIG. (See my post of November 16, 2008: http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)
I do not know who should replace Bernanke at this time. All I do know is that we have a new administration and a new economic team. Bernanke, I believe, does not have what it takes to get the financial and monetary situation straightened out. I believe that President Obama needs to appoint his own choice as Chairman of the Board of Governors of the Federal Reserve System.
Saturday, July 25, 2009
Is the Recession Over?
For the third month in a row the index of leading economic indicators rose. This is the first time this has occurred since 2004. And, it gives us some sign that maybe the economic recession that we have been in since December 2007 is reaching its climax. James W. Paulson, chief investment strategist at Wells Capital Management, is quoted in the Wall Street Journal as saying “We’ve got tons of information telling us we’ve turned the corner.” Ataman Ozyildirim, an economist at the Conference Board which produces the report, states that “The process of coming out of the recession, although still fragile, may be starting.”
I hope that these people are right and that we are coming out of the recession. There are fears of a “W” (not Bush) or a “double-dip” recession and these should not be discounted. But, we don’t really want the recession to carry on in any form; we really don’t want the risks associated with the down-side.Even though we may be at or near the bottom of the recession there are still plenty of concerns to deal with.
My continued concern is that the collapse in the economy was primarily due to a supply side shift and was not initiated by a fall in aggregate demand. This I have tried to capture in posts like my June 22 effort: http://seekingalpha.com/article/144508-structural-shift-in-the-u-s-economy-is-really-in-supply. If the recession was, in fact, initiated by supply shifts then there are structural dislocations in the economy that need taking care of that cannot be satisfied by just increasing aggregate demand to put people back in the jobs in which they were formerly occupied. We cannot just return to factories that are only being partially used or have been cvacated. Trying to push things back to where they were just postpones the restructuring of the economy that needs to take place.
In the past twenty years or so, we, in the United States, have experienced two credit bubbles or credit inflations. These bubbles have created excess growth first in information technology in the 1990s and then in the housing sector of the economy in the 2000s. But, these credit bubbles were not just restricted to the United States.There was a credit inflation throughout the whole world. Evidence of this has just been released in a report by Close Brothers Corporate Finance in the UK. (See “UK is Europe’s capital of distress” in the Financial Times: http://www.ft.com/cms/s/0/aba06ea2-758e-11de-9ed5-00144feabdc0.html.) The report claims that “The UK has western Europe’s highest percentage of financially distressed companies after being the leveraged buy-out capital over the past decade.” But, the report goes on to show that the credit bubble resulted in the serious collapse of the European manufacturing sector, as well as in the retail and leisure sectors. And, of course, there is the case of Japan in the 1990s and 2000s.
The problem created by credit bubbles or credit inflations (in addition to the excessive amounts of debt created) is that too much capacity is created in areas of the economy that cease to be needed any more once the bubble has burst. The normal response of the economy is to restructure so as to eliminate the excess capacity that exists and re-deploy resources into areas that are experiencing growth and development. A Keynesian effort to “pump up” aggregate demand is just an effort to re-employ resources in the same areas that formerly prospered but that now need to be “down-sized.”
This does nothing to get rid of the excess capacity and postpones the restructuring of the economy. Furthermore it retains the misallocation of financial capital that evolved during the period of the credit inflation or credit inflations.
The drop in capacity utilization in the United States since the start of the recession has been extremely dramatic. Firms have gone from using about 81% of their capacity to using only 68%, a drop of 16%. This is the steepest drop for the longest period of time in the data series.But, even more important in my mind is that capacity utilization has been dropping steadily since 1967.
Obviously, capacity utilization drops in periods of economic recession. Yet, as the economy has recovered in every economic cycle in the United States since the 1960s capacity utilization, after a recession, has never returned to the peak level it reached in the previous period of economic expansion. Thus, capacity utilization has trended lower throughout this time, evidence that there has been a shift in the structure of manufacturing in the United States.
Although the United States has grown around 3% compounded annually over the last forty years and employment, through most of the period, has been at relatively high rates, there are still two pieces of information that are rather unsettling. The first is the continuing decline in capacity utilization just mentioned. The second is the decline in the civilian participation rate. For the United States, this rate peaked in the 1990s a little above 67.0% and has declined through the late 2000s remaining below 66.2% since 2004. This may not seem like much of a fall but it indicates that a lot of people have left the labor force!The latter problem can be confirmed by figures from the Bureau of Labor Statistics.
There are major sectors of employment in the United States that have experienced significant reductions in jobs and employment. These are in industries that one could seriously argue were in substantial need of restructuring. (I will return to this topic soon in another post.) The question is, should people to be pushed right back into these jobs again by a government stimulus program of increasing aggregate demand? Instead, it seems as if there needs to be a significant education of a large portion of the civilian population that would like to participate in the labor force again.
If there are structural problems in the United States and in the world that result from the existence of excess capacity in industries that are declining or less technologically relevant, shouldn’t we let these industries decline or try to become technologically relevant rather than stagnant? Should we try and keep people producing buggy whips when there are means of transportation evolving other than buggies?So, to reclaim full economic health there is a need to reduce the excess capacity that has been built up in industries that are not so relevant any more and a need to deleverage financial structures. Unfortunately, a large portion of the needed financial deleverging is connected with firms that have excess capacity.
Furthermore, there is a need to restructure U. S. manufacturing and business, and train more of the workforce to fit into twenty-first century jobs so as to get the labor participation rate up.
In my study of the Great Depression, this is one of the reasons why it took so long for the United States economy, and the world economy, to recover through the 1930s. The structural change in the United States taking the country from an agricultural society to an industrial society did not really take place until the beginning of the Second World War My concern is that the needed current economic restructuring will be delayed if Washington continues to focus on companies with redundant capacity by stimulating the re-employment of the same workers that used to work in them. The economic statistics (the leading economic indicators) may continue to improve in such cases, but the economic recovery will continue to languish.
I hope that these people are right and that we are coming out of the recession. There are fears of a “W” (not Bush) or a “double-dip” recession and these should not be discounted. But, we don’t really want the recession to carry on in any form; we really don’t want the risks associated with the down-side.Even though we may be at or near the bottom of the recession there are still plenty of concerns to deal with.
My continued concern is that the collapse in the economy was primarily due to a supply side shift and was not initiated by a fall in aggregate demand. This I have tried to capture in posts like my June 22 effort: http://seekingalpha.com/article/144508-structural-shift-in-the-u-s-economy-is-really-in-supply. If the recession was, in fact, initiated by supply shifts then there are structural dislocations in the economy that need taking care of that cannot be satisfied by just increasing aggregate demand to put people back in the jobs in which they were formerly occupied. We cannot just return to factories that are only being partially used or have been cvacated. Trying to push things back to where they were just postpones the restructuring of the economy that needs to take place.
In the past twenty years or so, we, in the United States, have experienced two credit bubbles or credit inflations. These bubbles have created excess growth first in information technology in the 1990s and then in the housing sector of the economy in the 2000s. But, these credit bubbles were not just restricted to the United States.There was a credit inflation throughout the whole world. Evidence of this has just been released in a report by Close Brothers Corporate Finance in the UK. (See “UK is Europe’s capital of distress” in the Financial Times: http://www.ft.com/cms/s/0/aba06ea2-758e-11de-9ed5-00144feabdc0.html.) The report claims that “The UK has western Europe’s highest percentage of financially distressed companies after being the leveraged buy-out capital over the past decade.” But, the report goes on to show that the credit bubble resulted in the serious collapse of the European manufacturing sector, as well as in the retail and leisure sectors. And, of course, there is the case of Japan in the 1990s and 2000s.
The problem created by credit bubbles or credit inflations (in addition to the excessive amounts of debt created) is that too much capacity is created in areas of the economy that cease to be needed any more once the bubble has burst. The normal response of the economy is to restructure so as to eliminate the excess capacity that exists and re-deploy resources into areas that are experiencing growth and development. A Keynesian effort to “pump up” aggregate demand is just an effort to re-employ resources in the same areas that formerly prospered but that now need to be “down-sized.”
This does nothing to get rid of the excess capacity and postpones the restructuring of the economy. Furthermore it retains the misallocation of financial capital that evolved during the period of the credit inflation or credit inflations.
The drop in capacity utilization in the United States since the start of the recession has been extremely dramatic. Firms have gone from using about 81% of their capacity to using only 68%, a drop of 16%. This is the steepest drop for the longest period of time in the data series.But, even more important in my mind is that capacity utilization has been dropping steadily since 1967.
Obviously, capacity utilization drops in periods of economic recession. Yet, as the economy has recovered in every economic cycle in the United States since the 1960s capacity utilization, after a recession, has never returned to the peak level it reached in the previous period of economic expansion. Thus, capacity utilization has trended lower throughout this time, evidence that there has been a shift in the structure of manufacturing in the United States.
Although the United States has grown around 3% compounded annually over the last forty years and employment, through most of the period, has been at relatively high rates, there are still two pieces of information that are rather unsettling. The first is the continuing decline in capacity utilization just mentioned. The second is the decline in the civilian participation rate. For the United States, this rate peaked in the 1990s a little above 67.0% and has declined through the late 2000s remaining below 66.2% since 2004. This may not seem like much of a fall but it indicates that a lot of people have left the labor force!The latter problem can be confirmed by figures from the Bureau of Labor Statistics.
There are major sectors of employment in the United States that have experienced significant reductions in jobs and employment. These are in industries that one could seriously argue were in substantial need of restructuring. (I will return to this topic soon in another post.) The question is, should people to be pushed right back into these jobs again by a government stimulus program of increasing aggregate demand? Instead, it seems as if there needs to be a significant education of a large portion of the civilian population that would like to participate in the labor force again.
If there are structural problems in the United States and in the world that result from the existence of excess capacity in industries that are declining or less technologically relevant, shouldn’t we let these industries decline or try to become technologically relevant rather than stagnant? Should we try and keep people producing buggy whips when there are means of transportation evolving other than buggies?So, to reclaim full economic health there is a need to reduce the excess capacity that has been built up in industries that are not so relevant any more and a need to deleverage financial structures. Unfortunately, a large portion of the needed financial deleverging is connected with firms that have excess capacity.
Furthermore, there is a need to restructure U. S. manufacturing and business, and train more of the workforce to fit into twenty-first century jobs so as to get the labor participation rate up.
In my study of the Great Depression, this is one of the reasons why it took so long for the United States economy, and the world economy, to recover through the 1930s. The structural change in the United States taking the country from an agricultural society to an industrial society did not really take place until the beginning of the Second World War My concern is that the needed current economic restructuring will be delayed if Washington continues to focus on companies with redundant capacity by stimulating the re-employment of the same workers that used to work in them. The economic statistics (the leading economic indicators) may continue to improve in such cases, but the economic recovery will continue to languish.
Sunday, July 19, 2009
What Do The Money Stock Figures Tell Us?
The two basic measures of the money stock continue to grow at rapid rates. The broader measure of the money stock has continued to grow at a relatively steady pace. In the fourth quarter of 2008, the M2 measure of the money stock grew at an 8.2% year-over-year rate of increase. (I use non-seasonally adjusted data in all cases relying on year-over-year calculations to take account of seasonal movements in each series. Thus, I don’t rely on the artificial statistical adjustments that produce the seasonally adjusted series.) In the first quarter of 2009 the M2 year-over-year rate of growth was 9.5% but the rate of increase dropped back down to 8.7% in the second quarter.
These growth measures are high historically, but only modestly higher than the rates of growth that were being achieved before the Federal Reserve began pumping up its balance sheet in September and October of 2008. The important thing is the changes that have taken place within this broad measure of the money stock. The movement has been from time and savings accounts to transaction accounts as people have moved their funds from accounts that are interest-earning to those that are basically used to make payments.
The first look at a smaller component of the M2 money stock is to examine the performance of the M1 money stock. For the first half of 2008, the M1 money stock hardly grew at all on a year-over-year basis. But, in the third quarter this measure began to increase as the financial meltdown occurred. For the third quarter the M1 money stock grew at a 3.1% year-over-year pace, but this jumped up to 11.4% in the fourth quarter, followed by a 13.4% growth rate in the first quarter of 2009 and a 16.3% rate of increase in the second quarter.
The monthly year-over-year growth rates for April, May, and June of 2009 were 15.1%, 15.3% and 18.4%, respectively. Something is happening within the M1 measure of the money stock that is not happening to the non-M1 component of the M2 money stock which remained relatively flat during these three months.
What is growing?
Well, demand deposits at commercial banks grew by 44.3% year-over-year, in June 2009, up from 33.1% and 34.5% in April and May, respectively. This is also up from slightly under 30.0% for the first quarter of the year. People and businesses are moving their money into transactions accounts in order to have funds available to meet their day-to-day spending needs.
We see a similar jump in “Other Checkable Deposits” at commercial banks and thrift institutions as these accounts were growing by more that 12.0% in June 2009, up from 6.5% and 7.2% in April and May, respectively. In the first quarter of the year these accounts were only increasing at around a 2.5% to 3.0% rate of growth.
Another component of the M1 money stock is also increasing quite rapidly. Coin and currency held outside of commercial banks has been steadily rising by more than 11.0% year-over-year every month in 2009. A year ago the pace of growth in coin and currency was about one-half of what it is now. Again, one can only draw the conclusion that people are buying more and more things with cash now than they were a year ago. This is another indication of the fact that so many people are unemployed or are going bankrupt.
Where are the funds going into transaction accounts coming from?
The sources of these shifts seem to have been from primarily two areas, Small-denomination time deposits and retail money funds. There has been a drop of about $90 billion in deposits in retail money funds over the past twelve months. The decline in these accounts, year-over-year, is now about 8.5%. The rate of increase in small-denomination time deposits has dropped by 50% in the last six months and there has been an outflow of about $110 billion from these accounts since December 2008.
The conclusions one can draw from these data, I believe, are very clear. People and businesses have become much more conscious of their need to have cash and deposits available for meeting their daily living needs. People and families are moving funds from their small, low interest-earning accounts where they have not been earning much at all. These same people and families seem to be leaving funds in bigger accounts that earn higher rates of interest. It will be interesting to see what happens to these accounts in upcoming months if unemployment continues to rise and bankruptcies remain at high levels. In addition, businesses have found that other short term sources of funds are not available and so have had to become more liquid in order to satisfy their cash demands.
One could argue that the actions of the Federal Reserve have had little stimulative impact through the banking system since the rate of growth of the M2 measure of the money stock has only increased slightly so that the rapidly increasing rate of increase in the M1 measure of the money stock has resulted from individuals and businesses redeploying their short term assets.
This conclusion is reinforced by the information repeated in my July 16, 2009 post on “The State of the Banking System.” (See http://seekingalpha.com/article/149272-the-state-of-the-banking-system.) Commercial banks are not lending except in to consumers and just to consumers that have pre-arranged lines of credit like equity lines on homes and credit cards. This just supports the argument that people are doing what they can to make day-to-day ends meet. And, commercial and industrial loans have actually declined on a year-over-year basis. The argument can be made that no one is going to do anything that would lead one to conclude that economic units are going to increase their spending in a way that will stimulate the economy.
We need to continually watch what is going on in the banking sector. We are going to watch for further changes in behavior that might indicate the changing decisions of families and businesses. Of course, things could get worse and we need to watch for that. But, if things are going to get better, one place to look for changes in behavior is to watch where people are allocating their short term funds and whether or not banks are beginning to lend again. However, it doesn’t seem as if this change for the better will appear soon.
These growth measures are high historically, but only modestly higher than the rates of growth that were being achieved before the Federal Reserve began pumping up its balance sheet in September and October of 2008. The important thing is the changes that have taken place within this broad measure of the money stock. The movement has been from time and savings accounts to transaction accounts as people have moved their funds from accounts that are interest-earning to those that are basically used to make payments.
The first look at a smaller component of the M2 money stock is to examine the performance of the M1 money stock. For the first half of 2008, the M1 money stock hardly grew at all on a year-over-year basis. But, in the third quarter this measure began to increase as the financial meltdown occurred. For the third quarter the M1 money stock grew at a 3.1% year-over-year pace, but this jumped up to 11.4% in the fourth quarter, followed by a 13.4% growth rate in the first quarter of 2009 and a 16.3% rate of increase in the second quarter.
The monthly year-over-year growth rates for April, May, and June of 2009 were 15.1%, 15.3% and 18.4%, respectively. Something is happening within the M1 measure of the money stock that is not happening to the non-M1 component of the M2 money stock which remained relatively flat during these three months.
What is growing?
Well, demand deposits at commercial banks grew by 44.3% year-over-year, in June 2009, up from 33.1% and 34.5% in April and May, respectively. This is also up from slightly under 30.0% for the first quarter of the year. People and businesses are moving their money into transactions accounts in order to have funds available to meet their day-to-day spending needs.
We see a similar jump in “Other Checkable Deposits” at commercial banks and thrift institutions as these accounts were growing by more that 12.0% in June 2009, up from 6.5% and 7.2% in April and May, respectively. In the first quarter of the year these accounts were only increasing at around a 2.5% to 3.0% rate of growth.
Another component of the M1 money stock is also increasing quite rapidly. Coin and currency held outside of commercial banks has been steadily rising by more than 11.0% year-over-year every month in 2009. A year ago the pace of growth in coin and currency was about one-half of what it is now. Again, one can only draw the conclusion that people are buying more and more things with cash now than they were a year ago. This is another indication of the fact that so many people are unemployed or are going bankrupt.
Where are the funds going into transaction accounts coming from?
The sources of these shifts seem to have been from primarily two areas, Small-denomination time deposits and retail money funds. There has been a drop of about $90 billion in deposits in retail money funds over the past twelve months. The decline in these accounts, year-over-year, is now about 8.5%. The rate of increase in small-denomination time deposits has dropped by 50% in the last six months and there has been an outflow of about $110 billion from these accounts since December 2008.
The conclusions one can draw from these data, I believe, are very clear. People and businesses have become much more conscious of their need to have cash and deposits available for meeting their daily living needs. People and families are moving funds from their small, low interest-earning accounts where they have not been earning much at all. These same people and families seem to be leaving funds in bigger accounts that earn higher rates of interest. It will be interesting to see what happens to these accounts in upcoming months if unemployment continues to rise and bankruptcies remain at high levels. In addition, businesses have found that other short term sources of funds are not available and so have had to become more liquid in order to satisfy their cash demands.
One could argue that the actions of the Federal Reserve have had little stimulative impact through the banking system since the rate of growth of the M2 measure of the money stock has only increased slightly so that the rapidly increasing rate of increase in the M1 measure of the money stock has resulted from individuals and businesses redeploying their short term assets.
This conclusion is reinforced by the information repeated in my July 16, 2009 post on “The State of the Banking System.” (See http://seekingalpha.com/article/149272-the-state-of-the-banking-system.) Commercial banks are not lending except in to consumers and just to consumers that have pre-arranged lines of credit like equity lines on homes and credit cards. This just supports the argument that people are doing what they can to make day-to-day ends meet. And, commercial and industrial loans have actually declined on a year-over-year basis. The argument can be made that no one is going to do anything that would lead one to conclude that economic units are going to increase their spending in a way that will stimulate the economy.
We need to continually watch what is going on in the banking sector. We are going to watch for further changes in behavior that might indicate the changing decisions of families and businesses. Of course, things could get worse and we need to watch for that. But, if things are going to get better, one place to look for changes in behavior is to watch where people are allocating their short term funds and whether or not banks are beginning to lend again. However, it doesn’t seem as if this change for the better will appear soon.
Thursday, July 16, 2009
The State of the Banking System
There are three preliminary indicators that the banking system is coming along on its way to recovery. First, there is the “letting go” of CIT Group, Inc. The government must feel that it does not need to extend itself to help out this institution given its present troubles. (See my recent post on the CIT situation: http://seekingalpha.com/article/148730-cit-s-debt-issues-show-why-the-economy-won-t-be-picking-up-any-time-soon.) We’ll see if they continue this approach with other troubled institutions as additional situations arise.
Second, there is evidence that the regulators are taking a harder line at Bank of America and Citigroup. Each has its own problems, but the Feds seem to believe that they can step up their demands on these two financial institutions concerning boards, managements, business affairs, and so forth. They would not do this if they believed the system to be too fragile.
Third, I sense the Federal Reserve backing off from the more aggressive stance it took with respect to the bond markets one to two months ago. This is just a feeling that I will be following up on in the near future.
These actions provide some preliminary evidence that we are in the “working out” stage of the credit cycle where time is the biggest factor to contend with. Bailouts are needed to prevent “liquidity” problems when markets might crumble under cumulative selling pressures. But, this is a short run problem.
The “work out” phase of a financial crisis is the period when institutions still have severe credit problems but are not under short term pressures to relieve their balance sheets of “toxic” or “underwater” assets.
This does not mean that there will not be more failures of financial institutions and some of them may be relatively large ones. What it does mean is that the problems that still exist within the financial sector can be handled in a relatively orderly fashion. So, the banks and the regulators can operate within an environment that does not seem “desperate.” Severely troubled still, but not in a state of panic.
Within this scenario, the questions that remain about the banking system relate to earnings. We have seen Goldman Sachs and JPMorgan Chase & Co. post strong gains for the second quarter. However, most of the gains were attributed to trading activities, with secondary help from their underwriting business. These are not good, solid “banking” results. And, these organizations are highly diversified and can post returns from these areas, something that most other banks in the United States cannot do.
Still, the banking system seems to be in the stage of recovery where current cash flows can allow the individual banks to write off more and more of their loans and other assets over time and thereby restore the integrity of their balance sheets. With the results it achieved in trading and underwriting, JPMorgan Chase was able to take large write downs of home equity loans, mortgage defaults, and credit card charge offs while also increasing the amount of funds it set aside to increase its loan loss reserve. This is what other banks will be doing to reduce the burden of bad assets they are now carrying.
Overall, Total Assets in the commercial banking system grew by 8.9% from June 2008 to June 2009. The capital residual (Assets less Liabilities) in the system grew by 7.6% so that the capital asset ratio of the banking system dropped from 10.2% to 10.1%.
In terms of how the banks are attempting to protect themselves, the Cash assets of Commercial Banks in the United States were up 186%, year-over-year, in June 2009, although this rate of increase is down from a year-over-year rate of increase of 236% increase in May 2009.
Total Loans and Leases in the banking system rose just about 1.4%, year-over-year, in June while Commercial and Industrial Loans actually decreased by 3.1%. Commercial banks are just not lending to businesses which continues the trend which began last year. Banks are lending to consumers, up 5.5% year-over-year (primarily on credit cards and other revolving credit plans), and on real estate, up 6.4% year-over-year (the largest jump coming in revolving home equity loans).
The cash assets held in the commercial banking system declined regularly throughout June as the peak in cash assets held was reached in May. Thus, it appears that banks are backing off from taking everything the Federal Reserve has put into the banking system and stashing it away in “cash accounts”. This is confirmed by the aggregate banking data put out by the Federal Reserve which indicates that total reserves in the banking system dropped throughout June 2009 and the excess reserves also fell from peak levels reached in late May.
Thus, it appears that things are working out pretty much as the Fed hoped they would. (See my explanation of what the Fed has been trying to do, http://seekingalpha.com/article/145913-is-treasury-s-tarp-debt-already-monetized-part-ii.) Of course, the game is not over yet!
Bottom line: the banking system is working through its problems. The Federal Reserve and the regulators seem to be backing off a little, allowing the system to adjust over time to its dislocations. There is still room for a surprise, but, the more time passes, the less likely a surprise is likely to occur. In other words, the unknown unknowns have been substantially reduced and the known unknowns are what we are working on.
The banks are not lending except on established credit lines (credit cards and home equity loans) and there appears to be plenty of liquidity in the system as a whole. Whereas the lack of lending slows up the possibility for an economic recovery, it is an essential component of getting the banking system healthy again which is needed if there is to be any chance of a robust economic recovery in our future.
Second, there is evidence that the regulators are taking a harder line at Bank of America and Citigroup. Each has its own problems, but the Feds seem to believe that they can step up their demands on these two financial institutions concerning boards, managements, business affairs, and so forth. They would not do this if they believed the system to be too fragile.
Third, I sense the Federal Reserve backing off from the more aggressive stance it took with respect to the bond markets one to two months ago. This is just a feeling that I will be following up on in the near future.
These actions provide some preliminary evidence that we are in the “working out” stage of the credit cycle where time is the biggest factor to contend with. Bailouts are needed to prevent “liquidity” problems when markets might crumble under cumulative selling pressures. But, this is a short run problem.
The “work out” phase of a financial crisis is the period when institutions still have severe credit problems but are not under short term pressures to relieve their balance sheets of “toxic” or “underwater” assets.
This does not mean that there will not be more failures of financial institutions and some of them may be relatively large ones. What it does mean is that the problems that still exist within the financial sector can be handled in a relatively orderly fashion. So, the banks and the regulators can operate within an environment that does not seem “desperate.” Severely troubled still, but not in a state of panic.
Within this scenario, the questions that remain about the banking system relate to earnings. We have seen Goldman Sachs and JPMorgan Chase & Co. post strong gains for the second quarter. However, most of the gains were attributed to trading activities, with secondary help from their underwriting business. These are not good, solid “banking” results. And, these organizations are highly diversified and can post returns from these areas, something that most other banks in the United States cannot do.
Still, the banking system seems to be in the stage of recovery where current cash flows can allow the individual banks to write off more and more of their loans and other assets over time and thereby restore the integrity of their balance sheets. With the results it achieved in trading and underwriting, JPMorgan Chase was able to take large write downs of home equity loans, mortgage defaults, and credit card charge offs while also increasing the amount of funds it set aside to increase its loan loss reserve. This is what other banks will be doing to reduce the burden of bad assets they are now carrying.
Overall, Total Assets in the commercial banking system grew by 8.9% from June 2008 to June 2009. The capital residual (Assets less Liabilities) in the system grew by 7.6% so that the capital asset ratio of the banking system dropped from 10.2% to 10.1%.
In terms of how the banks are attempting to protect themselves, the Cash assets of Commercial Banks in the United States were up 186%, year-over-year, in June 2009, although this rate of increase is down from a year-over-year rate of increase of 236% increase in May 2009.
Total Loans and Leases in the banking system rose just about 1.4%, year-over-year, in June while Commercial and Industrial Loans actually decreased by 3.1%. Commercial banks are just not lending to businesses which continues the trend which began last year. Banks are lending to consumers, up 5.5% year-over-year (primarily on credit cards and other revolving credit plans), and on real estate, up 6.4% year-over-year (the largest jump coming in revolving home equity loans).
The cash assets held in the commercial banking system declined regularly throughout June as the peak in cash assets held was reached in May. Thus, it appears that banks are backing off from taking everything the Federal Reserve has put into the banking system and stashing it away in “cash accounts”. This is confirmed by the aggregate banking data put out by the Federal Reserve which indicates that total reserves in the banking system dropped throughout June 2009 and the excess reserves also fell from peak levels reached in late May.
Thus, it appears that things are working out pretty much as the Fed hoped they would. (See my explanation of what the Fed has been trying to do, http://seekingalpha.com/article/145913-is-treasury-s-tarp-debt-already-monetized-part-ii.) Of course, the game is not over yet!
Bottom line: the banking system is working through its problems. The Federal Reserve and the regulators seem to be backing off a little, allowing the system to adjust over time to its dislocations. There is still room for a surprise, but, the more time passes, the less likely a surprise is likely to occur. In other words, the unknown unknowns have been substantially reduced and the known unknowns are what we are working on.
The banks are not lending except on established credit lines (credit cards and home equity loans) and there appears to be plenty of liquidity in the system as a whole. Whereas the lack of lending slows up the possibility for an economic recovery, it is an essential component of getting the banking system healthy again which is needed if there is to be any chance of a robust economic recovery in our future.
Monday, July 13, 2009
CIT and Getting Out Of This Mess
CIT is an example of the kind of problems still facing the economy. CIT has taken on legal counsel in order to determine whether or not it should go into bankruptcy. The problem, the company has $2.7 billion in debt coming due through year end and its credit-rating has been cut “deep into ‘junk’ territory.” (See http://online.wsj.com/article/SB124744080839729811.html#mod=testMod.) It has been seeking liquidity help from the Federal Government but has not received approval yet.
Debt is the problem and it currently continues to haunt most businesses, governments, and individuals in the economy. It is a problem because this debt load has to work itself out. But, in working out the debt problem, the economy suffers and will continue to suffer.
The current debt crisis is so severe because of the credit inflation created by the U. S. Government over the last eight years of so. During expansions, credit inflations take place. This is what happens as the economy is stimulated and confidence in the private sector builds and things appear to be good and getting better. Credit inflations don’t have to directly result in general price inflation, although they can end up with this result.
In the 1990s as well as the 2000s we have had credit inflations where price increases have been relatively mild. In the 1990s we saw the stock market bubble and the credit inflation with respect to new ventures. However, during that decade we saw the federal government turn a deficit budget into a surplus budget by the end of the century. In the 2000s, we saw the housing bubble and the general credit inflation, but we also experienced a huge increase in government debt on top of everything else. Debt was good and most partook of it!
If the credit inflation during a period of economic expansion is not too excessive then the following correction that must take place can be relatively mild and reasonable and the government can come in and re-flate the economy so that the financial dislocation can be righted in a reasonable amount of time without too much “hurt” in the economy in general. Moral hazard is created, but what’s the problem with a little moral hazard? Right?
This is what happens in most minor recessions.
An exception occurred in the credit inflation of the 1970s. President Nixon was so paranoid about getting re-elected that he set about inflating the economy and connected this with taking the United States off the gold standard, floating the dollar, and freezing wages and prices. This philosophy was not abandoned by President Ford. Jimmy Carter just inflated, period. And, by the end of the decade, serious work had to be done to bring general inflation under control.
What happened in the decade of the 2000s was of a totally different nature. The debt structure that was created through this decade’s credit inflation could not be sustained. Debt was growing way more rapidly than the economy could support and the resulting imbalance was greater than at any time since the Second World War. Almost everyone was excessively over leveraged. The headlines focused first upon the subprime market and then upon Structured Investment Vehicles (SIVs) and the Collateralized Debt Obligations (CDOs). And, then it became apparent that this excessive leveraging had been going on everywhere in the economy. And, the federal government was right up there with everyone else.
There is too much debt out there! Yes, there is deficient aggregate demand, but that is not going to be corrected until the debt situation is corrected...no matter how much Paul Krugman and the Keynesian wing of the world cry out! People and businesses are going to have to get their balance sheets in order before private spending will really pick up. Unless, of course, the government is able to get a hyper inflation going again which is the classic solution for an economy with too much debt.
There are three ways for economic units to reduce debt. The first is to sell assets and pay off the debt. However, if people are uncertain about asset values this solution to the debt problem is not going to work. Second, economic units can save out of income and revenues and pay down their debt. This, of course, is the soundest way to de-leverage, but it is also the slowest way to reduce the debt on a balance sheet. The third way to reduce debt is to renounce the debt: that is, declare bankruptcy. This solution does have repercussions, however, on the value of the assets of other people and other businesses.
A firm with too much debt can face another problem. Debt matures and sometimes has to be refinanced. The problem here is that a company may not be able to refinance the debt that is coming due. In such cases, these firms will either be forced into the first way of reducing debt, selling assets and perhaps taking a loss on the sale of the assets, or it will have to renounce the debt by declaring bankruptcy.
One sees CIT examining its resources to decide what is its best option. The second option does not seem to be a viable option because CIT doesn’t have sufficient time to generate enough revenues so that it can pay down its debt. So, it is looking at a situation where it has a substantial amount of debt maturing in the next six months or so. Refinancing is an option, but with its bond ratings reduced to the ‘junk’ category, this could be quite expensive and could produce negative cash flows so that earnings could not provide revenues to pay down debt. Thus, CIT could reduce sell off assets to generate cash to pay off the maturing debt. But, how much does CIT stand to lose if it sells off assets?
If these are the scenarios, then it is good that CIT is getting advice on declaring bankruptcy. This still presents a problem. As people see this possibility facing the company, why should short term lenders continue to help finance the company and why should borrowers continue to borrow from CIT, a company that may not be there tomorrow. Also, on Monday morning investors dumped the company’s stock.
The fact of the matter is that there are many companies, governments, and individuals (and their families) that face this situation right now. And it is very, very scary.
The question is, given these problems, why should these economic units spend? They have a debt problem. And, with rising unemployment and more and more debt coming due in various sectors of the economy, like commercial real estate, why should we expect people to pick up their spending in the near term. There are other, more pressing issues to deal with. This is why the economy is not going to start to pick up much speed soon.
Almost every week there is a new “CIT” that we read about. These companies are too big to ignore. And, that is what is so worrisome. How many more of them are there?
Something else that is worrisome as well. When banks are closed by the FDIC, the general operating procedure is to place the deposits and good assets of the closed bank with a healthy bank. Word is that there are not that many healthy banks around. Thus, the deposits and good assets of banks that are closed are not being placed with healthy banks (See “FDIC’s Challenge with Busted Banks,” http://online.wsj.com/article/SB124744606526030587.html#mod=todays_us_money_and_investing.) So, we now have more banks that have been focused on their own problems taking on the problem of integrating the deposits and good assets of closed banks which can’t help but divert their attention from their own problems. As of last Friday, 53 banks have been closed this year and the expected total of bank closings for the year is over 100. If we don’t have a lot of healthy banks around now to take care of the current crop of banks that are closing, what are we going to do for the rest of the year?
Debt is the problem and it currently continues to haunt most businesses, governments, and individuals in the economy. It is a problem because this debt load has to work itself out. But, in working out the debt problem, the economy suffers and will continue to suffer.
The current debt crisis is so severe because of the credit inflation created by the U. S. Government over the last eight years of so. During expansions, credit inflations take place. This is what happens as the economy is stimulated and confidence in the private sector builds and things appear to be good and getting better. Credit inflations don’t have to directly result in general price inflation, although they can end up with this result.
In the 1990s as well as the 2000s we have had credit inflations where price increases have been relatively mild. In the 1990s we saw the stock market bubble and the credit inflation with respect to new ventures. However, during that decade we saw the federal government turn a deficit budget into a surplus budget by the end of the century. In the 2000s, we saw the housing bubble and the general credit inflation, but we also experienced a huge increase in government debt on top of everything else. Debt was good and most partook of it!
If the credit inflation during a period of economic expansion is not too excessive then the following correction that must take place can be relatively mild and reasonable and the government can come in and re-flate the economy so that the financial dislocation can be righted in a reasonable amount of time without too much “hurt” in the economy in general. Moral hazard is created, but what’s the problem with a little moral hazard? Right?
This is what happens in most minor recessions.
An exception occurred in the credit inflation of the 1970s. President Nixon was so paranoid about getting re-elected that he set about inflating the economy and connected this with taking the United States off the gold standard, floating the dollar, and freezing wages and prices. This philosophy was not abandoned by President Ford. Jimmy Carter just inflated, period. And, by the end of the decade, serious work had to be done to bring general inflation under control.
What happened in the decade of the 2000s was of a totally different nature. The debt structure that was created through this decade’s credit inflation could not be sustained. Debt was growing way more rapidly than the economy could support and the resulting imbalance was greater than at any time since the Second World War. Almost everyone was excessively over leveraged. The headlines focused first upon the subprime market and then upon Structured Investment Vehicles (SIVs) and the Collateralized Debt Obligations (CDOs). And, then it became apparent that this excessive leveraging had been going on everywhere in the economy. And, the federal government was right up there with everyone else.
There is too much debt out there! Yes, there is deficient aggregate demand, but that is not going to be corrected until the debt situation is corrected...no matter how much Paul Krugman and the Keynesian wing of the world cry out! People and businesses are going to have to get their balance sheets in order before private spending will really pick up. Unless, of course, the government is able to get a hyper inflation going again which is the classic solution for an economy with too much debt.
There are three ways for economic units to reduce debt. The first is to sell assets and pay off the debt. However, if people are uncertain about asset values this solution to the debt problem is not going to work. Second, economic units can save out of income and revenues and pay down their debt. This, of course, is the soundest way to de-leverage, but it is also the slowest way to reduce the debt on a balance sheet. The third way to reduce debt is to renounce the debt: that is, declare bankruptcy. This solution does have repercussions, however, on the value of the assets of other people and other businesses.
A firm with too much debt can face another problem. Debt matures and sometimes has to be refinanced. The problem here is that a company may not be able to refinance the debt that is coming due. In such cases, these firms will either be forced into the first way of reducing debt, selling assets and perhaps taking a loss on the sale of the assets, or it will have to renounce the debt by declaring bankruptcy.
One sees CIT examining its resources to decide what is its best option. The second option does not seem to be a viable option because CIT doesn’t have sufficient time to generate enough revenues so that it can pay down its debt. So, it is looking at a situation where it has a substantial amount of debt maturing in the next six months or so. Refinancing is an option, but with its bond ratings reduced to the ‘junk’ category, this could be quite expensive and could produce negative cash flows so that earnings could not provide revenues to pay down debt. Thus, CIT could reduce sell off assets to generate cash to pay off the maturing debt. But, how much does CIT stand to lose if it sells off assets?
If these are the scenarios, then it is good that CIT is getting advice on declaring bankruptcy. This still presents a problem. As people see this possibility facing the company, why should short term lenders continue to help finance the company and why should borrowers continue to borrow from CIT, a company that may not be there tomorrow. Also, on Monday morning investors dumped the company’s stock.
The fact of the matter is that there are many companies, governments, and individuals (and their families) that face this situation right now. And it is very, very scary.
The question is, given these problems, why should these economic units spend? They have a debt problem. And, with rising unemployment and more and more debt coming due in various sectors of the economy, like commercial real estate, why should we expect people to pick up their spending in the near term. There are other, more pressing issues to deal with. This is why the economy is not going to start to pick up much speed soon.
Almost every week there is a new “CIT” that we read about. These companies are too big to ignore. And, that is what is so worrisome. How many more of them are there?
Something else that is worrisome as well. When banks are closed by the FDIC, the general operating procedure is to place the deposits and good assets of the closed bank with a healthy bank. Word is that there are not that many healthy banks around. Thus, the deposits and good assets of banks that are closed are not being placed with healthy banks (See “FDIC’s Challenge with Busted Banks,” http://online.wsj.com/article/SB124744606526030587.html#mod=todays_us_money_and_investing.) So, we now have more banks that have been focused on their own problems taking on the problem of integrating the deposits and good assets of closed banks which can’t help but divert their attention from their own problems. As of last Friday, 53 banks have been closed this year and the expected total of bank closings for the year is over 100. If we don’t have a lot of healthy banks around now to take care of the current crop of banks that are closing, what are we going to do for the rest of the year?
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