China Buys the World

I missed the news.

And, I presume a lot of others also missed the news.

“In the weeks ahead, a 104-year-old unit of General Motors will be sold to new owners from China. The unit made steering equipment for decades under the name Saginaw Steering Gear. Now known as Nexteer, it employs 8,300 people around the world. It new Beijing owners call themselves Pacific Century Motors.” (http://professional.wsj.com/article/SB10001424052748703957804575602943255219552.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

China is, and has been, buying companies throughout the world.

“But,” the above article goes on, “it is one of the landmark deals of the era, the first time Chinese investors have bought a U. S. industrial operation of such scale and history: Twenty-two factories around the globe, six engineering centers, 14 customer-support centers.”

The only direct way to stop this activity is through capital controls and other forms of protectionism.

The United States Congress did balk at some earlier attempts by China to purchase U. S. companies that were considered to be threatening to American security interests. Still, China continues to seek out and acquire United States companies.

I have mentioned this behavior on the part of the Chinese before. But, the Chinese are not alone…other emerging countries are engaging in the purchase of American companies as well.

And, the United States government continues to feed China and these other countries with the means to buy American countries.

“Ironically, at the G-20 conference in Seoul this week, U. S. leaders are trying to cajole China to buy more from the U. S., to help right a trade deficit that hit $28 billion in August alone. Such imbalances, they say, helped feed the credit craze that culminated in the 2008 financial crisis.”

In my mind, the “U. S. leaders” don’t get it!

The United States government continues to inflate the world with dollars and dollar-denominated U. S. Treasury securities and then encourages these foreign governments to buy American companies to combat the trade deficits that they have been instrumental in creating.

What am I missing here?

The United States government is inflating the world with dollars because the unemployment rate is too high and then encouraging foreign governments to buy American companies to put these people back to work again.

Again, what am I missing here?

And, why should the Chinese government want the situation to change. The Chinese government is in the driver’s seat and the United States is just feeding it with the means to buy companies both in the United States and in the rest of the world.

The Chinese have no reason to change the existing situation.

And, as long as the leaders in the United States government keep pointing their fingers at the Chinese and saying that the problem is out there…the problem will be that of the United States continuing to feed the rest of the world the means to acquire America.

But, this will not continue forever. The United States Congress will not allow it.

The threat, then, is as described by the German chancellor Angela Merkel stated in an interview with the Financial Times, is the imposition of controls and protectionism. (http://www.ft.com/cms/s/0/3cb912ca-eb6f-11df-b482-00144feab49a.html#axzz14tWucN4h)

This will not be good for either world trade or for international cooperation and peace.

But, the United States government shows no inclination to change its behavior. The leaders in the government are still working off of an outdated and inappropriate economic model. They are also working with an outdated ego that claims that America can still “go-it-alone” in the world.

Unfortunately, these outdated ideas are working entirely against what the United States would like to achieve. It is hard when you are your own worst enemy!

And, the United States continues to shoot itself in the foot. There is an excellent op-ed piece in the Wall Street Journal this morning by Alan Reynolds. (See Ben Bernanke’s Impossible Dream”: http://professional.wsj.com/article/SB10001424052702303467004575574610003111250.html?mod=ITP_opinion_0&mg=reno-wsj)

Although though Reynolds concentrates the focus of the article on the Bubble Ben’s quantitative easing plan, I could not help but think about who would benefit from the consequences of the “easing” that is presented. All the consequences described by Reynolds will benefit the wealthy because they are the only ones that are in a position to take advantage of the incentives that will be created by the quantitative easing.

This policy, then, will have three ultimate effects. First, income (wealth) inequality will continue to increase in the United States. The economic policies followed by the United States over the past fifty years which are just variations on the quantitative easing policy, have created a massive shift toward a more unequal distribution of income (wealth) in America. But, in an attempt to help the less-well-off, the government will continue to follow its existing policy-prescriptions.

Second, the United States will continue to become less and less productive. This is one of the criticisms leveled by Wolfgang Schäuble, the German Finance Minister. Schäuble stated that the reason for the strength of German exports was the fact that German industry was so effectively productive. He implied that other countries, like the United States, were not as competitive. The United States will be even less so if the results Reynolds foresees are achieved.

Third, given the current economic philosophy of the United States government, the leaders of the government will continue to combat this loss of competitiveness by “more-of-the-same” in terms of economic policies. This will just continue to hand the Chinese, and others, the means to acquire American companies.

Following such a path will result in the Obama administration achieving exactly what it does not want to happen. But, this is precisely what the Obama administration has achieved in the less than two years it has been in charge of the United States government.

And, why should China want anything different?

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 Banking System Seems to be Dividing: Large Versus Small

The last three months have seen more and more weakness in the smaller commercial banks in the United States. Last month I ask the question, “Is A Crunch Coming for the Smaller Banks?” (http://seekingalpha.com/article/229385-is-a-crunch-coming-for-smaller-banks)

This month things continued to decline amongst the smaller banks while the largest 25 banks in the country really seemed to expand.

Over the past four weeks ending Wednesday October 27, the biggest 25 banks in the country saw their assets increase by almost $94 billion while the assets at the smaller banks rose by only about $8 billion; but the cash assets at the smaller banks rose by almost $19 billion.

Over the past quarter, the total assets at the larger domestically chartered banks increased by a little less than $20 billion while the assets at the smaller banks actually declined by about $9 billion. Cash assets at the smaller commercial banks rose by over $33 billion during this time.

Loans and leases at the smaller commercial banks have fallen by $14 billion over the last four weeks and by almost $32 billion over the last 13-week period. And, where has most of this decline come from? Commercial real estate loans!

This is, of course, is where many analysts, including Elizabeth Warren, have predicted the trouble would come from until the end of 2011 or so. Warren even stated in congressional testimony that there were some 3,000 commercial banks that were going to face severe problems in the commercial real estate area as these loans either matured and had to be re-financed or went into a delinquent status.

Over the past four-week period, commercial real estate loans at the smaller banks fell by almost $10 billion. Over the past 13-week period, these loans dropped by over $23 billion.

Looking back over the past year ending in September, commercial real estate loans at the smaller commercial banks declined by $74 billion, with half of the decline coming in the last six months.

The decline in assets at the smaller commercial banks is coming exactly where Warren and others warned they would come. But these banks also moved more and more into cash assets during this time indicating a very risk averse position. Over the past thirteen weeks the smaller banks did exactly the opposite of what their larger competitors did: the smaller banks added $33 billion to their cash asset portfolios while the bigger institutions reduced their cash by $30 billion.

The largest 25 banks are still not aggressively pursuing loans. But, their securities portfolios continue to increase. Over the last four weeks, securities held by the largest banks in the country increased by almost $32 billion while they rose by almost $60 billion over the past 13-week period.

This behavior is also exhibited over the last twelve months, ending in September 2010. During this period, large commercial banks increased their securities portfolio by almost $125 billion while their portfolio of Commercial and Industrial loans fell by almost $80 billion and their portfolio of real estate loans dropped by $41 billion.

Some of the financing of these securities came from the cash assets of these large banks which declined by almost $70 billion during this time period. The largest supplier of new funds to these institutions came from something called “Borrowings from Others”. In essence, the larger banks seem to be playing an arbitrage game. They are borrowing short and buying long term securities. The risk to them seems minimal since the Federal Reserve is keeping short term interest rates exceedingly low for “an extended time.” An “extended time” seems to go well into next year.

The largest commercial banks are going to do just fine. They will continue to get stronger and bigger in the future.

The smaller banks continue to struggle. The problem here is that we, the public, really don’t have a handle on how serious the situation is with respect to the solvency of the smaller commercial banks in the banking system.

The “surprise” sale of Wilmington Trust last week took most people by surprise, even the very astute analysts. (See http://seekingalpha.com/article/234027-wilmington-trust-sold-at-45-discount.) Here is a bank known for its conservatism and, in addition, it was solidly producing earnings through its trust department. Yet, the bank had failed to really report the truth about its loan portfolio. Here is a bank, roughly around $10 billion in asset size with bad assets totaling around one billion dollars. How could this happen without someone knowing about it?

How many more commercial banks like Wilmington Trust are out there?

Bankers…lenders…do not like to admit that they have bad loans. In general, they postpone reporting bad loans until it is too late for them…and their shareholders.

Elizabeth Warren said that there were about 3,000 commercial banks in the banking system that were going to face serious strains over their commercial real estate loan portfolio and their construction loan portfolio.

Recent data indicate that large dollar amounts of commercial real estate loans are leaving the balance sheets of the smaller commercial banks in the United States. It would appear as if more and more of these bad assets are being recognized and removed from the banks’ balance sheets.

More and more people are calling for commercial banks to recognize their bad assets so that the United States can start to grow again. I believe that more and more people are realizing that a strong economic recovery is not possible until something is done about these bad assets…until they are written off the balance sheets of the commercial banks.

One of the problems that the Obama team is really going to have to deal with soon is to appoint some people to provide economic and regulatory advice and administration. On the economic side, only Tim Geithner at Treasury and Austan Goolesbee at the President’s Council of Economic Advisors are in place. On the regulatory side connected to depository institutions, only “Bubble” Ben will be in place by the middle of next year. The Office of the Comptroller of the Currency has an acting head. I was at a banking conference last week and there was talk that Sheila Bair, Chair of the FDIC is expected to leave next year and does not want to be re-appointed. The Office of Thrift Supervision is merging into the OCC and the top people are looking elsewhere for leadership. Many leadership positions are empty.

One could almost say there is little or no leadership at the top in Washington, D. C. when it comes to economics and banking.

And yet, 2011 could be a crucial year in American history for determining the future of the structure of the financial system.

Bubble Ben, the Bubble Maker

It seems like all Ben Bernanke can do is blow bubbles. He joined the Board of Governors of the Federal Reserve System in September 2002 and served until June 2005. The effective Federal Funds rate was 1.75% at the time of his arrival. By July 2003, this rate was 1.00%. The effective Federal Funds rate remained at 1.00% until July 2004.

Bernanke not only supported this exceedingly low rate during the year it served as the Federal Reserve target, he provided a large portion of the intellectual support for such a policy. Remember Bubble Ben was an historical expert of the Great Depression and former head of the Princeton Economics Department.

The consequence of the Federal Reserve policy? Bubbles in both the stock market and the housing market.

He then went off to become the Chairman of the President’s Council of Economic Advisors, another tough executive position with lots of leadership challenges, where he stayed until January 2006 when he was appointed as the Chairman of the Board of Governors of the Federal Reserve System, the second most powerful executive position in the United States government.
In February 2006, the effective Federal Funds rate was 4.50%. Now, of course, Bernanke’s major concern was inflation, so the effective Federal Funds rate was pushed up to 5.25% until July 2007 after the bubble had already burst. He stayed too long at the dance! The Fed Funds rate dropped below 4.00% in January 2008 and below 3.00% in February 2008.

Once the financial crisis spread Bernanke saw the Fed Funds rate drop below 1.00% in October 2008 and by December 2008 the effective Federal Funds rate dropped below 25 basis points where it has remained ever since.

Now we have another “Spaghetti” experiment called “Quantitative Easing 2, where we have Bernanke saying that the Fed will buy up to $900 billion in United States Treasury securities over the next eight months or so. (See “Bernanke’s Next Round of Spaghetti Tossing”, http://seekingalpha.com/article/233773-bernanke-s-next-round-of-spaghetti-tossing. Also see http://seekingalpha.com/article/234814-the-fed-s-850-billion-bet-negative-long-term-implications.)

Mr. Bernanke, “Bubble Ben”, is erratic and subject to panic. He seems calm and rational and “in control” but his actions imply something else. His volatility in response to what he considers to be a crisis, whether it is a financial collapse or inflationary pressures is not consistent with outstanding leadership qualities. But, why should we expect such leadership qualities from someone who has only been tested in the confines of the economics department at Princeton?

The problem is that what Bubble Ben is doing is impacting the whole world. The American stock market is booming. Commodity markets are booming. The price of gold hit an all-time high. The bond market is soaring…”A bevy of household names rushed to sell cheap debt on Thursday after the Federal Reserve said it would pump at least $600 billion into the financial system…At least $12 billion in high-grade bonds came to market making it one of the busiest days in nearly two months.” (http://professional.wsj.com/article/SB10001424052748703805704575594111859145030.html?mod=ITP_moneyandinvesting_5&mg=reno-wsj) And you can expect a lot more high-grade companies coming to the market to issue more debt in coming days.

And the value of the dollar is tanking. Against major currencies, the value of the dollar is down by about 7% since late August.

The expectation is that massive amounts of dollars will flow out of the United States into, especially, emerging nations. “The US Federal Reserve’s decision to pump an extra $600 billion into the economy has galvanized emerging market central banks into preparing defensive measures…China, Brazil and Germany criticized the Fed’s action on Thursday, and a string of east Asian central banks said they were preparing measures to defend their economies against large capital inflows.” (http://www.ft.com/cms/s/0/981ca8f4-e83e-11df-8995-00144feab49a.html#axzz14PXUVIN6) The expected outflow is already resulting in substantial stock market gains in emerging nations.

This move by the Fed is certainly not going to foster good feelings and co-operation among the leaders of the world as they get ready to “go-to-meeting” in Seoul, South Korea for the assembling of the G-20.

This surge in capital flows is being called “inappropriate and short-sighted” by many countries and the move is seemingly resulting in additional currency tensions and a high risk of capital controls and trade protectionism. This is not just a “textbook” exercise. This is real stuff. As Martin Wolf has said in the Financial Times, America is exporting inflation to the rest of the world.

The rest of the world is not going to stand by and let this happen.

But, this leads into another point. The United States is contributing to its declining influence in the global economy. The United States will not be dropped from its leadership position in the world, but other nations are becoming relatively important and are becoming more and more assertive in standing up to the United States in more and more important issues.

With this action the United States is making the unity of the G-20 impossible. America has taken its stance. It is solely focusing on its navel. Why should other countries bow down to it anymore?

In fact, if this action does anything, it seems that it is drawing these other nations together to possibly counteract the Fed’s actions.

For those nations that want to see the United States weakened, the Federal Reserve is playing right into their hands. In fact, I cannot think of a policy that would be more helpful in reducing the influence of the United States in the world as the one the Federal Reserve has set out on.

We can joke about “Bubble Ben” and how he likes to blow bubbles. Unfortunately, bubbles don’t last. Bubbles pop! And, when they pop many, many people suffer.

Unfortunately, there seem to be lots of bubbles forming and they seem to be spreading throughout the world. What is really going on here?

Here Comes the Spaghetti! The Fed's $850 Billion Bet.

The headline reads that the Federal Reserve is going to engage in a new round of quantitative easing. The Fed is going to purchase an additional $600 billion in U. S. Treasury securities over the next eight months, or $75 billion per month, in order to get the economy growing again.

The information that did not make the headlines is that over the same time period, roughly $250 billion will run off of the Fed’s Mortgage-backed securities portfolio. This $250 billion in Mortgage-backed securities will be replaced by the Fed with $250 billion in U. S. Treasury securities.

The world investment community sees a Washington, D. C. is disarray. The Fed is going crazy. (But, this is not the first time that Bernanke has shown panic. See “The Bailout Plan: Did Bernanke Panic”, http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.) And, the additional federal deficit is projected to be at least $15 trillion over the next ten years.

What we are seeing, in my mind, is the culmination of a half century or more of governmental economic policy that has had the wrong focus. This began with the Employment Act of 1946. Full employment became a goal of the United States government and the Federal Reserve was charged with the task of contributing to the achievement of this goal.

Right now, the Fed believes that there will be little or no stimulus programs coming from the federal government, especially with the changes in the makeup of Congress resulting from this week’s election. Thus, the Fed seems to believe that it must carry the full burden of reducing unemployment.

We have reached this state of desperation over a long period of time. The background of this environment is presented in the book by Raghuram Rajan called “Fault Lines” which just won the Financial Times award for the best business book of the year. (See my review of this book: http://seekingalpha.com/article/224630-book-review-fault-lines-how-hidden-fractures-still-threaten-the-world-economy-by-raghuram-g-rajan.) The next five paragraphs contain material from this review.

Rajan states that “Almost every financial crisis has political roots.” Beginning from this premise, he discusses the foundation of the economic policies of the United States. The root of the government’s economic policies, he contends, is the concern over “the growing inequality of income” in the United States, a disparity that can lead to political unrest.

Politicians, however, have not responded to this problem by focusing on the longer run solutions to inequality connected with education and opportunity, but has instead focused on short run solutions because of the nature of the American political process.

Rajan argues that these politicians have responded to the discontent this divergence in incomes creates in the electorate with two short run panaceas: first, the effort to achieve high levels of employment through the monetary and fiscal policies of the government. This resulted in the Employment Act of 1946 and the Humphrey-Hawkins Full Employment Act of 1978. The second is the effort to help as many individuals as possible own their own homes.

Thus the government has created policies that underwrite efforts to attain high levels of economic growth and employment and will provide downside protection against economic contractions and unemployment. Likewise, it will underwrite the supportive credit inflation of the private sector and will “save” financial institutions experiencing trouble on the downside.

Home ownership has become the default policy of government in the inequality debate because efforts to directly combat income inequality in the United States, Rajan contends, have been exiled from political debate. Supporting home ownership for as many people as possible and in as many ways as possible has been substituted. As a consequence, the number of programs, institutions, and incentives advocated for home ownership has grown to the point where they dominate most economic and social policies of the United States government. Credit creation is the vehicle of choice for the achievement of homeownership and prancing from “bubble to bubble” has become the essence of the fiscal and monetary policy that supports this effort.

The problem is that these policies don’t work over the longer run. In fact, the efforts to achieve success in these areas over time may do more to help the wealthy and educated at the expense of the less-wealthy and the less-educated.

In the fifty years that the efforts Rajan describes have been incorporated into the economic policy of the federal government, the United States has actually seen the inequality of incomes become even more skewed toward the higher end of the income spectrum.

And, it appears that most of the efforts of the Obama administration to protect and better the position of the less-wealthy and the less-educated have done exactly the opposite of what the administration intended!

For example, look at this article by Shahien Nasiripour in Huffington Post this morning, “Federal Reserve Rains Money on Corporate America—but Main Street Left High and Dry”. (http://www.huffingtonpost.com/2010/11/03/federal-reserve-qe2_n_778392.html)

So, who has benefitted from the policy of the Federal Reserve? The big banks. Big corporations. Emerging nations. (More and more of these countries are thinking of imposing controls on money flows to stem the flood of dollars coming across their borders), China. India. Brazil.

You don’t see on this list smaller banks, smaller businesses, middle class Americans, and so on.

And, who is capable of positioning themselves to take advantage of these federal monetary and fiscal policies? The wealthy and the educated…not the less wealthy or the less-educated.

Just a case in point: as the credit inflation of the 1960s and 1970s built up, the wealthy began to build portfolios of assets that served as inflation hedges. Houses, of course, were one of these assets.

In fact, housing became the piggy bank of many, many Americans during this time. But, since the prices of housing never went down during this period of credit inflation it appeared that one way to help the less-well-to-do in the society was to help them get a “piece of the bank.” The subprime loan was one of the last vehicles to get people into the piggy bank. I mean, how could they miss with housing prices rising 10% to 12% year-after-year. And, the Fed would never let these people down for long.

And, what about unemployment? Unemployment may actually be made worse by too much credit inflation. Trying to put people back into the jobs they have recently lost through credit inflation may only make the employment situation worse as under-employment grows, as it has over the past fifty years, and as capacity utilization declines, as it has over the past fifty years.

I really can see little or no good coming from this “quantitative easing”. However, I can imagine a lot of bad things happening. The plunge that is now taking place in the value of the dollar leads me to believe that a lot of other people believe the same thing.

What Money Stock Growth is Telling Us

The year-over-year rate of growth of the money stock measures has never declined during the Great Recession of 2008-2009.

The recession began in December 2007. In January 2008 the year-over-year rate of growth of the M2 measure of the money stock was 6.0%; the M1 measure was growing at 0.5%. Currently, the M2 measure is growing at a 3.0% year-over-year rate of growth; the M1 measure is growing at 6.3%

The interesting thing about the behavior of these money stock measures is what happened within each measure. I have regularly reported on this behavior over the past 18 months or so. (See, for example, “The Recent Behavior of the Monetary Aggregates”: http://seekingalpha.com/article/218818-the-recent-behavior-of-the-monetary-aggregates.)

Looking at the monetary aggregates over this period of time reveals two movements. The first movement is the transferring of funds from small time and savings deposits and short-term money funds into transaction balances. The second movement is the transferring funds from thrift institutions to commercial banks. These movements can be attributed to the low interest being paid on these accounts and in these funds and to the employment uncertainty that hovers over many families in the United States. This is not a real positive sign in terms of a country attempting to get its economy going again.

Over the past three months, the Federal Reserve System has ended its “exit strategy” and taken a more neutral stance with respect to monetary policy. (See http://seekingalpha.com/article/233760-federal-reserve-non-exit-watch-part-3.) At the present time, the world seems to be waiting for another effort at Quantitative Easing. (See http://seekingalpha.com/article/233773-bernanke-s-next-round-of-spaghetti-tossing.)

Regardless of what these “grand” strategies are and what they might accomplish…or, not accomplish…it is still instructive to see what people actually seem to be doing with their money.

Basically, when looking at the monetary aggregates we see the same behavior over the past several months that we have seen exhibited by the private sector over the past twenty-four months. People continue to transfer their wealth into transactions balances and currency holdings while reducing wealth held in the smaller savings deposits and in retail money funds.

That is, the families and individuals still believe that they can most be prepared for the future by keeping their money is ways that can be spent without having to transfer funds from other accounts in order to be able to spend them. Any interest that might be earned on these latter balances is just too small to warrant these people from being any more less liquid.

Overall, the M1 measure of the money stock in the third quarter of 2010 was 5.3% higher than it was one year ago. The quarterly year-over-year growth rates for M1 fell during the year, averaging 7.9% in the first quarter of 2010 and 5.5% in the second quarter.

The M2 measure remained relatively constant in the first and second quarter of this year, averaging 1.9% and 1.6% respectively, but increased at a 2.5% rate in the third quarter. The non-M1 component of the M2 measure only increased at a 0.5% year-over-year rate of growth in the first quarter; it rose to 0.7% in the second quarter; and rose by 1.8% in the third quarter.

The biggest change contributing to the rise in the non-M1 component of M2 was the slowdown in the rate of decline in money held in Retail Money Funds. In the six months of the year, these accounts declined at a rate slightly more 25%. However, the rate of decline dropped to about 22% in the third quarter. Overall, retail Money Funds dropped by more than $160 billion from September 2009 to September 2010.

The decline in small time deposits stayed around 22% all year. Small time deposits fell by almost $280 billion from September 2009 to September 2010.

Where have these funds gone? Primarily into transaction balances.

The growth rate of demand deposits at commercial banks has remained relatively robust over the past year. This growth, connected with the decline in small time accounts and retail money funds, is the reason why the rate of increase in the M1 measure was greater than the growth rate of the M2 measure.

Demand deposits rose at a 7.6% year-over-year rate of increase in the first quarter of 2010; the growth rates for the rest of the year were 6.3% in the second quarter and 8.5% in the third quarter.

The interpretation of all this is as follows: people have, once again, begun re-allocating more of their wealth into transactions balances and currency. Although this movement slowed earlier this year, it began to pick-up once again in the third quarter.

In a real sense, this is not encouraging. To me this movement is what happens when people and businesses transfer their wealth into forms that are convenient for daily needs in order to purchase necessities. This deposit growth is not coming because the Federal Reserve is pumping a lot of base money into the banking system. The growth is not coming because the commercial banks are lending…they are not lending. This movement of funds seems to be to purchase the basic goods needed to live and survive.

The good news is that the money stock measures are growing. The not-so-good news is that the money stock growth is growing because people and businesses need to keep their funds very liquid for the purpose of daily living.

I cannot believe that a new round of quantitative easing is going to change this picture.

NOTE: Money going to Institutional Money Funds actually began to increase in absolute value in July 2010 and continued to increase through September. The year-over-year rate of decline in these monies is still quite large (-23% in the third quarter) but it is a smaller decline than from the first two quarters of the year.

Wilmington Trust Sold at Forty-Five Percent Discount

Bank lenders are always among the last to accept the fact that the loans they have placed in their loan portfolio might be bad.

“Oh, the economy will improve and the loans will improve with the economy.”

“These borrowers got hit with an unusually bad turn of events, but they are putting things together and the loans will improve as they get things in order.”

Bank lenders are optimists. They have to be. They also wear blinders when things go bad.

The problems that exist in bank loan portfolios have been one of my major concerns over the past two years. Check my blog posts if you don’t believe me.

The question has always been, “How big of a hair cut will banks need to take in order to truly reflect the value in their loan portfolios?

Remember that the TARP was initially supposed to help financial institutions get bad assets, unmarketable assets, off their balance sheets. That was a long time ago.

Elizabeth Warren, earlier this year in Congressional testimony, suggested that 3,000 commercial banks faced severe problems over the next 18 months with respect to their commercial real estate loans. There are less than 8,000 banks left in the banking industry.

The FDIC has nearly 900 banks on its list of problem banks. The FDIC has been involved in about 3.5 bank closings per week since the beginning of the year and this is expected to continue into 2011. But, how many more banks are on the verge of being included in this list? At least as many banks as are now listed?

And, for a long time I have been accusing the Federal Reserve of keeping the banking system extremely liquid so as to not create another banking crisis. By keeping the banking system liquid the Fed contributes to a more stable banking system that allows the FDIC to close banks more smoothly, which is just what has happened.

The price that Wilmington Trust is taking from M & T is approximately 45% of the Wilmington Trust stock price on Friday. The valuation of the bank is roughly at book value…or, at least, at currently reported book value.

Monday the bank reported that it raised the level of its non-performing loans to almost $1.0 billion and its loan loss provision rose to almost $300 million up from about $40 million one year ago. Note that Wilmington Trust has just over $10 billion in assets.

Reports indicated that Wilmington Trust had been in negotiations with Spain’s Banco Santander “for months.” Executives at Wilmington Trust has known for a while of their weak condition. This effort fell through and the bank then cut a deal with M & T.

This transaction, and admission, should color the whole commercial banking industry…at least for those banks that fall below the largest 25 banks in the country. (Note that these 25 banks control two-thirds of the assets held by commercial banks in this country.)

How big a loss is still hidden on the books of the commercial banks in the United States? How much information is the regulators hiding from not only the public but from elected officials in the United States? How long can this charade continue?

When all of the regulators operate in such a “closed book” fashion and are so united…it makes one wonder. Why is the Federal Reserve, the FDIC, the Treasury Department, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision working in such unison in this area…and providing so little information about what is going on?

One can add to this list the treatment of Fannie Mae and Freddie Mac. In reality, we, the people, are getting nothing from our government about what is really going on and the seriousness of the situation.

What is currently going on is one of the reasons why I am in favor of “fair market accounting” or “mark-to-market” accounting.

Commercial banks, before-the-fact, have got to present some kind of information on the value of the assets they have on their books. The fundamental reason for having banks “mark-to-market” their assets is that these banks must realize that if they acquire long term assets or take on more and more risky assets that they may, eventually, have to write those assets down should the market move against them. To me, “mark-to-market” accounting should be prevent excessive risk taking because the bankers know what they might have to do if things turn against them. In this respect these accounting practices are not meant to be an “after-the-fact” punishment.

I understand all the problems associated with trying to estimate the value of some of the assets. However, this very fact should cause bankers to be more cautious when they put such assets on their balance sheets.

How many shareholders would have liked to have had this information? Would the shareholders of Wilmington Trust have benefited by knowing that the stock they held was only about 50% of the going market value? This is information the shareholders should have!

Commercial bankers, especially loan officers, hate to admit their mistakes. In all my experience in banking, loan officers are the most reluctant people to admit that something might not be working out right.

It is this kind of attitude that has gotten us into the position we now find ourselves. How threatened is the capital base of the commercial banking industry? How many banks are truly insolvent? How are all these insolvencies going to be worked out? Who is eventually going to pay for all the insolvencies? And, we should not leave out Fannie Mae and Freddie Mac from the accounting.

The fate of Wilmington Trust is a shocker to many of us. As the Federal Reserve prepares to throw more spaghetti against the wall (http://seekingalpha.com/article/233773-bernanke-s-next-round-of-spaghetti-tossing) and the FDIC continues to work out more and more bank failures and the Thrift Industry closes its doors, we can only hope that the transition through these problems continues to cause as little disruption as possible. I am still betting that there will only be around 4,000 depository institutions in the United States at the end of 2015. Can this “halving” of the banking industry be done quietly?

Given this environment, however, how can we expect that bank lending will show many signs of life in the near term?

If this is the case, where is the credit to finance a recovery going to come from? Can quantitative easing really get the economy going again if the banking system is unable to lend?

How many more Wilmington Trust banks are out there?