Back to 1991: the FDIC

FDIC chairwoman Sheila Bair introduced two unusual ideas last week: one, that banks should prepay their assessed fees through 2012 by the end of this year; two, that the FDIC might indeed end up borrowing substantial amounts from Treasury in order to manage liquidity.  The reason for this, of course, is that the 98 bank failures year-to-date (through October 2, 2009) have put a heavy strain on the Deposit Insurance Fund (DIF).   Having started out the year with $17.3 billion in assets the fund’s balance was down to $10.4 billion at the end of June and has just dipped into negative territory – a first since 1991 at the height of the savings & loans crisis.

The fact that the DIF is in the red is not highly worrisome in and of itself, in my opinion.  What is worrisome, though, is that the FDIC is expecting bank failures to continue at a similar pace next year, and that the DIF is expected to stay in the red through 2012 and at uncomfortable levels until 2017.  In addition, while the DIF is backed by the full faith and credit of the US government, Bair believes that borrowing from Treasury to solve the liquidity problem would be problematic  because “the American people would prefer to see an end to policies that looked to the federal balance sheet as the remedy to every problem.”

My more immediate concern is that if the FDIC does need to turn to Treasury for money, depositors will see the move as a sign of the potential lack of reliability of FDIC coverage; this in turn might easily prompt runs on the bank across the country, which would result in a vicious cycle that would put an added strain not just on the FDIC but also on the federal balance sheet.  How worried should we be about this?

For some quick back-of-the-envelope math: the FDIC had 416 (and rising) banks on its list of problem candidates at the end of June and is currently expecting losses to the DIF of ~$100 billion due to bank failures through 2013, 25% of which have already been realized.  The total number of commercial banks and savings institutions in the US is around 8200, or roughly 20x the number of institutions on the watch list.  The total amount of assets covered by the FDIC at the end of Q2 2009 was roughly $4.7 trillion or more than twice the size of the Fed’s balance sheet which stood at $2.2 trillion as of October 1.

Judging by the lack of news coverage of the DIF dipping into the red it seems to me that Washington is more than a little alarmed by the prospect of depositors panicking because of the FDIC’s lack of liquidity.  What do you think?

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What I Missed, And What I Make Of It

After having been blissfully unaware of any economic and market news since the end of March I am back in Boston, and it’s time  for me to get back into the game.  I’m still in the process of catching up, but here’s what I think the key developments over the last few months were:

1.  The market hit a (temporary) bottom in early March.  The Dow Jones is back at around 9,550, roughly 45% above its March 9 low of 6,547.05.  Similarly, the S&P500 is somewhere north of 50% above its March low.  At the same time, 30 year  Treasury yields are back in the neighborhood of 4.35% after having hit a bottom at 2.55% in late December 2008.

2.  Both Chrysler and GM declared bankruptcy; the two firms emerged from bankruptcy after no more than a few weeks each.  In addition to the troubled automakers there were 84 bank failures in 2009 through August, a full 63 of which occurred in between the end of April and now. 24 of those bankruptcies occurred in July, another 15 in August.

3. The US economy seems to recover, albeit slowly.  Unemployment stands at 9.4% but negative GDP growth slowed to -1.0% over the second quarter and durable goods orders were up.  Re-appointed Fed Chairman Ben Bernanke suggested in his speech last week that we have the worst behind us in this “most severe financial crisis since the Great Depression.”

But do we really?  Is the rally in the stock markets actually sustainable, especially without analogous interest rate increases?  What happens if the dollar crashes?  What if inflation picks up?  The futures markets do not seem particularly worried at the moment:  implied probability has the Fed Funds rate steady at 0.25% through the end of 2009 and then suggests and increase to 1.0% towards the end of the first quarter of 2010, suggesting steady progress on the course towards economic recovery.

My own conclusion at this point is simple: I’m at a loss.  I don’t see what should justify a stock market rally of the magnitude that we have seen.  I do see optimism that isn’t based on any real data (if you disagree please let us know!), and I believe that there’s a systemic problem lurking in the financial system that we prefer to ignore:  all the money that has been printed over the course of the last year.  When you look at the US monetary base and the level of excess reserves of depository institutions, the picture doesn’t look much different from seven months ago when I first wrote about it.

Bernanke suggested last week that “the continuing provision of liquidity and a tightening of the regulatory framework are key” to keep financial markets functioning properly.  It’s blatantly obvious that the provision of liquidity remains a top priority of the Fed at the moment, and our monetary base and excess reserves are still at levels that are barely different from the end of 2008 when the crisis was in full swing.  Looking at these charts doesn’t make me confident that we have the worst behind us. Or maybe we do, and what we are looking at is a systemic change in the financial system.  What do you think?

Hiatus – I’ll be back in August!

The title says it all: my next blog post will likely be up in August 2009, thanks to a four month sabbatical.  Hopefully by the time I return from Southeast Asia / New Zealand / Fiji, the various Fed & Treasury efforts will be having a lasting – positive – effect on the economy.  Regardless of if things will look better or worse, I am going to be back with charts and commentary on Wall Street and DC in the summer.  In the meantime, feel free to continue to leave comments on my previous posts (they’ve been a huge source of value-add so far, thanks to all who contributed!); I look forward to picking up where we left off later this year.

Increasing Toxicity: FAS 157 & Marking to Market

FAS 157, the accounting rule requiring financial institutions to mark their assets to market, has frequently been cited as a factor exacerbating the crisis. Steve Schwarzman is a vocal opponent of the mark to market rule in its current form, arguing that “the rule is accentuating and amplifying potential losses.”  And while I’m sure an accounting rule is not the cause of the mess we’re in, I don’t always see the cause for marking assets to market – especially if they are fixed income products intended to be held to maturity which suffer primarily from a lack of liquidity in the market and only secondarily from fundamental impairment.

Today there’s talk of potential changes to FAS 157; at a minimum, it seems like we can expect to see some guidance on the application of the rule that might qualify or relax the mark to market requirement.  I haven’t yet made up my mind if I should like this development – one half of me appreciates the potential relaxation based on the above reasoning (liquidity vs. fundamentals), but the other half fears that a decrease in transparency may cause prolonged or additional trouble down the road.

In addition to the impact FAS 157 has on asset markdowns, though, there’s another important side effect of the rule that tends to be forgotten:  financial institutions know that they will have to mark their books to market, using whatever price comparable securities last traded at when they value the securities still on their books; as a consequence, when banks unload parts of their portfolios of toxic assets, they will make sure to sell those securities that are of good enough quality to find buyers at the price that the bank’s’ book was last marked at – otherwise the bank would not only take an additional loss on the assets it is selling, but it would also have to take further writedowns on the securities remaining on its balance sheet.  In an environment like today – i.e. one of continuously deteriorating fundamentals – this means that sellers will have a strong incentive to sell higher quality assets first.   The result: increasing toxicity of the assets left on the balance sheets of financial institutions.  Where’s the silver lining?

The Credit Crunch – a Supply or Demand Problem?

Over the last few months we’ve seen a drastic increase in bank reserves.  As I’ve pointed out on previous occasions, banks are soaking up the liquidity provided by the Fed’s various programs and the credit crunch continues.  But what’s the reason?  Is it that banks are unwilling to lend in the current environment, trying to cap their losses? JPMorgan recently argued that it’s not the supply of credit that has collapsed, but the demand for it – consumers are hunkering down and have lost their appetite for spending;  businesses that suffer from weak demand don’t require as much credit as they do in prosperous times; and hedge funds have grown weary of leverage.  It’s a bit of a chicken and egg problem, but what do you think: is the credit crunch driven by the lack of  supply or the lack of demand?

The money multiplier is money stock M2 (money & close substitutes for money) over monetary base M0.

The Stressfree Stress Test

The Fed et al published their guidelines for the Supervisory Capital Assessment Program today, defining the parameters for the base case and adverse scenarios to be used in the bank stress tests.  As Paul Krugman points out the stress test scenarios are somewhat of a letdown.  The summary table below show the base case and adverse scenario assumptions for GDP growth, unemployment and home price appreciation over the next two years.  The original can be found here.

I was under the impression that a stress test should be designed to take a look at possible outcomes under extreme scenarios.  To me, the above hardly seems extreme – especially when comparing the HPA and unemployment numbers to what some of the MBS  hedge fund managers I talk to on a regular basis tell me they are using as their “conservative” assumptions: -35% for home prices, unemployment in the mid teens.  Is the government putting the banks through a useless exercise?

When Will Things Get Better?

Two days ago President Obama signed the 2009 stimulus package into law, committing an additional $787 billion to supporting the American economy.  A number of banks – JPMorgan, Citigroup, Bank of America and Wells Fargo among them – have agreed on temporary moratoriums on foreclosures. Weekly mortgage applications jumped 46% last week, and (as noted in my last post) a variety of indexes seem to be slowing their decline.  Credit Suisse recently suggested that the  much-bemoaned US debt to GDP ratio might not be in as bad a shape as commonly assumed. Yet the S&P500 lost -4.6% the day President Obama signed the American Recovery and Reinvestment Act, and the Dow Jones gave up -3.8%.  As of February 18, the Dow Jones has lost roughly 14% for the year.  I have no idea when equities are going to see a bottom or when the economy is going to reach a turning point.  I do believe, though, that there are certain prerequisites to be met before a lasting recovery can begin:

1) We need some signs that the stimulus package is working.

In their January meeting, the minutes of which were published yesterday, the Federal Open Market Committee once again reduced their 2009 growth projections.  The consumer confidence index stood at 37.7 in January, its all-time low since inception of the index in 1967.  I think that consumer and investor confidence will only tick up again as the tax cuts and spending programs of the $787 billion stimulus package (hopefully) prove their effectiveness over time – per the Congressional Budget Office’s estimates the stimulus will add somewhere between 1.1 and 3.8 percentage points to real GDP in 2009, and have an effect of similar magnitude in 2010.

Take a look at the charts below for a breakdown of the stimulus package, and an estimate from JPMorgan showing the sizing of tax breaks and spending quarter by quarter.  Please note that the JPMorgan graph dates to the first week of February and is thus not a fully accurate reflection of the stimulus package that was passed on February 13.

2) Systemic threats on both the national and international level need to be resolved.

Temporary calm returned to the US markets in December of 2008 after the government committed to “doing all that it takes” to thaw credit markets, stabilize the financial system and revive the economy.  Talk of an impending collapse of the US financial system subsided as it became clear that the government would do everything possible to prevent another Lehman disaster.  I believe that we need a similar commitment from the EU regarding the escalating situation in Eastern Europe, and from the US government and banks regarding the prevention of potential systemic shocks such as a large-scale municipal default (think California which just managed to corral the last vote needed to resolve the budget impasse) or a spike in mortgage defaults triggered by a wave of simultaneous interest rate resets.

3) We need to recalibrate our expectations regarding homeownership, leverage and GDP growth.

It seems that by now both Wall Street and Washington and have understood that we can’t go back to “business as usual” – i.e. our pre-crisis reality.  For a while to come, banks and hedge funds won’t be as leveraged as they were over the last decade.  American automakers need to revamp their business models.  I personally don’t believe that almost 70% of households in the US can afford owning a home (stay tuned for a post outlining why).  I don’t think that a personal savings rate in the zero to three percent range is sustainable.  And I don’t see how increasing reliance on debt – both private and public – can continue to drive GDP growth going forward.

The charts below show the US debt to GDP ratio (the revised version from Credit Suisse) over the last 100 years, the growth of GDP compared to the increase of productivity in the US since 1965, and the development of homeownership over the same period.   Looking at these long-term trends, I believe that we’re in for a prolonged period of pain – after all, the stimulus package addresses the symptoms of the crisis and not its causes: leverage is shifted from private to public, instead of being reduced; homeowners who can’t afford their homes are receiving support to avoid foreclosure.

What do you think needs to happen in order for things to get better?

How Much Further Do Equities Have to Fall?

The S&P500 is currently hovering around 800, almost -50% off of its October 2007 high.  And while the first optimistic pieces are starting to pop up in main street media, a number of sources – including some of Wall Street’s powerhouses – suggest that the S&P500 will bottom in the 650-700 area.  That’s another -12% to -19% from where we are today.  If you take a look at the below flurry of indicators (courtesy of JPM/Bloomberg/OECD) you get a sense for what these predictions are based on: bad news across the board.

What do you think – are we anywhere close to a bottom?

The Reaction to Geithner’s Rescue Plan

Over the last few days there has been plenty of press about how and why Geithner’s annoucement of the rescue plan on Tuesday spooked the markets. The Dow ended the day down -4.6%, financials were down somewhere around -10%.

That’s the equity side of things.  Corporate bonds suffered, too, on Tuesday as money flowed back to the perceived safety of Treasuries – but at least CDS showed no knee-jerk reaction to the Geithner plan: they did widen, but not materially.  A silver lining?

CDS on Select Banks (US & Intl) through February 13, 2009

The Quantity Theory of Money – V (Part Two)

This is a visual addendum to my earlier post about inflation vs. deflation and the quantity theory of money.  As a reminder, Friedman postulates that inflation is caused by an increase in the money supply; the quantity theory of money in its simple form states that the amount of money in an economy multiplied by its velocity equals the real value of goods in the economy times the price level, or M*V = P*Q.  So an increase in the money supply, ceteris paribus, should result in an increase in price levels.

As I noted last month, the US monetary base has recently seen drastic increases.  We haven’t seen rising inflation, though, because all the additional money that the Fed has been printing is getting soaked up by banks upping their reserves.  FT Alphaville’s Stacey-Marie Ishmael posted an impressive chart yesterday showing this decrease in the velocity of money.

You can find the original here.  And if you’re sifting through the FT Alphaville archives, also take a look at the hyperinflation scenario that Morgan Stanley sees as a (not highly likely, but realistic) possibility.