Rate Watch #808 2012

December 30 , 2011

by Dick Lepre  

 

 

2011 was a great year for folks invested in Treasuries because prices rose driving yields down. What happened this year and what will continue in 2012 is flight to quality buying of U.S. Treasuries as investors flee Euro denominated assets especially EU government debt. The problem is gigantic and politicians are unwilling or unable to forge a solution and sell it to their voters. The ECB and the Fed has backstopped the EU banking system to provide liquidity but two thing have to happen: 1) losses most be taken and some entities recapitalized and 2) EU members need to decide if they are willing to have nations with no responsible fiscal policy to remain part of the Union. These are not easy choices.

 

What will the economy see in 2012?

 

1) Since 2012 is a Presidential election year we will see massive amounts of b.s. from the candidates and the media which back them. Objective interpretation of the data will be difficult to find.

 

3) It is actually worse than that. It is difficult to objectively interpret that data when the data is bogus. Well, it isn't really more difficult it is more a waste of time. We recently say NAR (National Association of Realtors) revise the last 5 years of Existing Home Sales downward. Did anyone believe NAR before that? Does anyone believe NAR now?

 

GDP data is released each quarter with, essentially, two months of real data and one month of guesstimates. Why? This is very important data. Why not wait until BEA has three months of data and then make the first release. Why do the deflators used by BEA to correct for inflation not the same as inflation data from BLS? Why does BEA refuse to explain how they get these numbers?

 

The media concentrates on the Unemployment Rate when a better measure of economic health is the percentage of the population which is working (Labor Participation Rate.) The fact that the Unemployment Rate went down this month was more due to the large number of people who stopped looking for jobs rather that the number of people who actually found jobs. In November 120,000 found work and 315,000 gave up looking for a job. Is that supposed to be good news?

 

It is my view that we do a poor job of collecting and reporting economic fundamantals. I am going to talk about this a lot in the coming year and suggest alternate sources of data. That is why, for example, I have often handed over analysis of GDP to Rick Davis of Consumer Metrics Institute.

 

4) Fiscal vs. Monetary Policy vs. Politics

 

We try to make believe that fiscal policy "taxes and spending" and monetary policy (interest rates and size of the money supply) are separate domains but it is obvious that they no longer are. The collapse of the housing bubble still has a pervasive effect on: the banking system, the deficit, and the jobs market. Massive injections of liquidity on the part of the Fed staved off disaster but with the consumer still struggling to make his payments the effects of increased money supply and Keynesian stimulus have been minimal.

 

On top of this, the fact is that politicians do not make fiscal decisions for any economically rational reason but solely to increase their own power and their probability of reelection.

 

There is a connection between bad data and bad fiscal policy. Economist William Barnett makes that case that because of the complexity of financial instruments such as MBS, simple sum money aggregates do not give an adequate measure of money supply. Barnett has created a new measure of money supply called M4- or the Divisa Monetary Index. This weighs the various components of money supply. Just a few weeks ago the St. Louis Fed started reporting the Divisa Monetary Index calling it MSI (Monetary Services Index) . I will write about this some time in the next few months. This is a link to the St. Louis Fed's explanation of MSI.

 

5) A Continued Miserable Housing Market

 

The worst of the housing crisis is in the past but values are still falling. They will continue to do so until the excess inventory created by foreclosures and the delay of foreclosure is cleared. There are a lot of houses out there which can be had for low prices if one puts the time into it and picks up smoothing from a foreclosure sale. Last week there was celebration because New Home Sales for November were 315,000 (annualized.) While 315,000 is larger that the previous month's 307,000 it is still pathetic. And this is with 30 year fixed rates at 4%!

 

6) Continued Mistrust of Wall Street and Business

 

While it is easy to be dismissive of OWS because it mixed together a stew of things the fact is that the grievances are well-based. Investment bankers do too little investing and job creating. Corporate executives are too little concerned about the well-being of their companies and their customers and too much concerned about rewards from short term profits and management of the stream of data which affects the price of the company's stock. Investment banks which make buy/hold/sell recommendations are laughable. They refuse to make any significant number of sell recommendations because that would not be conducive to doing business with those companies in the future.

 

I do not see this so much as "something is wrong with the system" as something is wrong with the players. Corporate ownership is too spread out for anyone to able to offer a sort of moral guidance. In my view there are a lot of entities which should not even be corporations. Wall Street worked better when the investment banks were not public companies but partnerships. Is the solution reverting these to partnerships? Maybe. At least then would be no value in misrepresenting income or net worth.

 

7) EU

 

It will most likely be the case that interest rates here are driven not by any of the substantial issues above but rather by what happens in the EU. Concern over European banks will drive money to dollar denominated assets and perhaps send the 10 year yield closer to 1.5%.

 

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Dick Lepre
RPM - SF Van Ness

Who Got Bailed Out?

Rate Watch #805 Who Got Bailed Out?

December 9 , 2011

by Dick Lepre  

[email protected]
www.loanmine.com

 

Before we try to understand what bank bailouts are let's first ask a simple question: what exactly is a bank?

I think it is best if we regard a bank by looking at it as three sets of people 1) the stockholders 2) the customers who a) place deposits in the bank - these are liabilities to the bank and b) borrow money from the bank - these are the assets 3) the employees.

Keep this in mind: a bank's assets consist of the loans that it owns and whatever physical assets it may own (real estate, for example.) A bank liabilities consist of shareholder equity and its deposit liabilities. There are rules which regulate the relative size of the two classes of liabilities. A bank can only take in deposit liabilities which are a certain multiple of its shareholder equity. These rules are international and are set by the Bank for International Settlements.

On September 15, 2008 Lehman Brothers filed for Chapter 11 bankruptcy protection. Lehman had made large investments in mortgage backed securities. Worse yet, there were highly leveraged. Lehman was not a bank but an investment bank and was allowed by SEC to leverage itself almost 31:1. A 3.5% loss in the value of its mortgage assets could wipe out all of the equity in the company.

The Lehman BK let out of the bag the fact that all the large investment banks and many large commercial banks were holding a ton of mortgage debt which was going to see a much higher default rate than anticipated. The mortgage mess/liquidity crisis was launched. Potential retail buyers of these mortgage backed securities made up of crappy loans stopped buying them and the folks who held them - the investment banks and large commercial banks were stuck. This created a massive liquidity problem on top of the capital problem created by the losses.

Let's go back to the statement "A bank liabilities consist of shareholder equity and its deposit liabilities." Deposit liabilities consist of the deposits of the regular customers (individuals and businesses) and also interbank lending. Interbank lending is short term (one day to one week) lending from one bank to another. The need for this can arise at the end of any bank's business day. It may find that it has insufficient cash to cover its reserves. Banks with excess cash lend it to banks which are cash short every day. In general, banks face the task of funding long term loans with short term deposits. Some of these loans are things such as HELOC's, commercial lines of credit and credit cards where the borrowers have control over the balances.

Post-Lehman what happened is that no one trusted anyone else and interbank lending dried up. Since interbank lending was the normal solution to any bank's liquidity problem, business as usual was not an option. Banks were not concerned about making money. They were concerned about not suffering contagion from another bank's ills.

At that point there were two serious problems with banks 1) because the real value of their mortgage assets was a lot less that they thought they suffered a capital shortfall problem and 2) the mutual distrust created a liquidity problem.

The risk at this point was enormous. Two thing were done to help. One was TARP which addresed bank capital and the other was the liquidity programs put together by the Federal Reserve. TARP (Troubled Assets Relief Program) was passed by Congress and signed by Bush II. It authorized the expense of up to $700 billion of which $432 billion was ever disbursed. This was originally intended to shore up bank capital but banks rather quickly got their own capital and paid back TARP loans. Then TARP morphed into a bailout for AIG, FNMA, FHLMC, Chrysler and GM - none of which is a bank. Treasury has collected about $13.7 billion in interest or dividend on TARP and the eventual loss is estimated to be less than $20 billion.

Banks were bailed out but quickly repaid Treasury. But the populist myth misses the point. Bank stockholders were massive losers. Some such as Washington Mutual were totally wiped out while others were merely heavy losers. The bailout benefited the public in general. Absent a bailout, if banks had become insolvent then either depositors would have lost money or the FDIC (the public) would have made up the difference.

The most significant support when the liquidity crisis occurred came from the Federal Reserve in the form of a number of programs which provided a gigantic amount of money to a massive array of entities. These were broker dealers, banks, credit unions, and corporations.

This is a detailed blog piece I wrote explaining the various Fed liquidity programs.

The liquidity providing provisions of the Federal Reserve saved the economy from much larger disaster. They costs the taxpayers nothing and, in fact, earned a profit 95% of which went to Treasury. The bailout was more to everyone who had a bank account and lost zero than it was to banks per se. Some bank shareholders lost all the value of their equity. Other merely took large hits.

Preservation of the banking system benefited everyone. Letting almost the entire banking system fail was not an option. If these interventions had not occurred the losses to Treasury (the taxpayers) would have been much more massive and many businesses and jobs would have been destroyed. The message that somehow only banks were bailed out and the public was ignored misses the point as to what the functions of a bank are. It is the taxpayers and the depositors who were bailed out. The bank equity owners took large losses.

 

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Dick Lepre
RPM - SF Van Ness

[email protected]
Web site: www.loanmine.com
Blog: economy.typepad.com

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EU Debt Crisis by no Means Solved

The EU Debt Crisis

This past Wednesday was an excellent example of just how clueless investors are. There was a coordinated announcement by all major central banks that they would provide dollar liquidity to EU banks. The Dow went up 490.

What the banks promised were U.S. dollar swap liquidity facilities. This is being done because U.S. banks are reticent to provide short term loans to EU banks. The situation is nearly identical to the liquidity crisis of 2008. If interbank lending stops because banks don't trust that other banks are solvent then the central banks must take over.

This is akin to putting foam on the runway when a plane with landing gear trouble is about to land. The fact that the foam is there may be good news but the bigger picture is that nothing good is about to happen. The damages are being mitigated but in the present EU situation the underlying causes are fiscal and are not being addressed.

The goal is to get U.S. dollars into the hands of EU banks. Note that the U.S. Federal Reserve is not lending dollars to European banks. It is lending dollars to foreign central banks and those banks are responsible for the loans. Here is the Fed's reasoning as to why it is exposed neither to default not changes on currency values:

Dollars provided through the reciprocal currency swaps are provided by the Federal Reserve to foreign central banks, not to the institutions obtaining the funding in these operations. The foreign central bank receiving dollars determines the terms on which it will lend dollars onward to institutions in its jurisdiction, including how the foreign central bank will allocate dollar funds to financial institutions, which institutions are eligible to borrow, and what types of collateral they may borrow against. The terms governing these loans of dollars are in all cases released to the public by the foreign central banks. As the Federal Reserve's contractual relationship is exclusively with the foreign central bank and not with the institutions obtaining dollar funding in these operations, the Federal Reserve does not assume the credit risk associated with lending to financial institutions based in these foreign jurisdictions. The provision of dollars and receipt of foreign currency, and the receipt of dollars and return of foreign currency at the swap’s maturity date, both occur at the same foreign exchange rate so that the Federal Reserve is not exposed to movements in foreign exchange rates.

The Fed would lose money only if the ECB collapsed.

The fact is that this is an omen of recession in Europe. So we have impending EU recession, serious slowing of China's growth and +2.0% GDP growth here. This is what is driving a +490 point day for the Dow.

Some of the EU nations need to clean up their fiscal acts. So does the U.S.