Monday, April 30, 2012

Economic Growth for the First Quarter: Good Scenario for Bernanke

The year-over-year growth rate of real Gross Domestic Product came in just about as I forecasted. (  The year-over-year growth rate was 2.1 percent.   In the previous post I argued that real growth over the next year or so would be in the 2.0 percent to 3.0 percent range where the growth would tend to be closer to 2.0 percent than to 3.0 percent.  

The basic analysis of this performance concluded that the consumer sector and exports did well.  Business investment, real estate investment and the public sector did not do so good.  A mixed outcome, but still to the plus side.   The economy is growing and, I believe, that there are signs that the balance of factors supporting more growth are tending to outweigh the factors working to the down side.

Furthermore, I believe that this scenario is a good one for Fed Chairman Ben Bernanke.  Economic growth is continuing although the reduction in unemployment is not as great as he would like it…and especially as some of his fundamentalists Keynesian critics would like it. 

However, economic growth is continuing and this is good.  It means that if economic growth continues in the 2.0 percent to 3.0 percent range, the Federal Reserve will not have to engage in any further monetary stimulus at the present time. 

Mr. Bernanke and the Fed are reluctant to engage in anymore quantitative easing at this time because any further effort to stimulate the economy at this time will have little or no impact on how the economy will perform before the presidential election this fall and the Fed stands to reap a great deal of criticism during the election season if it appears to be underwriting the campaign of the incumbent. 

The Fed is also comfortable that there are sufficient reserves in the banking system to allow for the smooth closing or merger of “sick” commercial banks without any significant disruption to the financial system.  Last Friday, the FDIC closed 5 commercial banks bringing the total for the year to 22.  This year only 1.3 banks are being closed each week down from 1.8 banks per week in 2011.  This, of course, does not consider the reduction in the number of banks in existence due to mergers taking place.

The Fed, I believe, will continue to believe it is doing its job if the economy continues to grow, even at a modest pace, and the financial system continues to absorb bank failures and mergers without undue difficulty. 

The modest rate of growth of the economy takes pressure off the Fed to combat potential inflation due to all the reserves it has pumped into the banking system.  Possible rising inflation is the big fear of the future, but this concern will put less pressure on the central bank if the economy is not increasing very rapidly.  The Fed could even accept inflation a little bit above its (implicit) 2.0 percent target range for a time given the slow rate of growth of the economy.

In addition, it seems as if there is now some “downside” protection against economic growth dropping to a lower level.  Business lending at commercial banks seems to be picking up. ( The Fed has been waiting for bank lending to increase given all of the reserves it has put into the banking system.  Now the rise in loans is taking place and this will only strengthen the growth of the economy in the near term. 

There are, of course, still potential “bumps in the road” that could dislodge this picture.  One of these “bumps” is the fiscal “cliff” that more and more people are talking about, that the United States government is going to have to face later on this year.  Right now, how this issue will be dealt with is anybody’s guess. And, the US election seems to be muting discussion of the problems to be faced. (

And, there is the continuing saga of the European sovereign debt mess still playing at your local theaters.  This and a second recession can have serve consequences for the United States and the world, let alone for Europe.

It is still my belief that we will muddle through all of this.  And, for the time being, the pressure is off Mr. Bernanke.  Bernanke is sitting in about as good a place as he could be for the time being.  Of course, the situation could suddenly change.  However, I believe that the economy will keep on, keeping on.  And, this will not be the worst of all worlds.     

Thursday, April 26, 2012

Dow Jones at 15,000?

Jeremy Siegel, professor of Finance at the Wharton School, University of Pennsylvania, stated on CNBC yesterday, that the Dow Jones index will hit 15,000 by the end of next year.   (

I can live with this. 

In terms of profits, Siegel believes that the fundamentals are there.

The only thing Siegel sees that is holding back investors: “I’m increasingly believing what Federal Reserve Chairman Ben Bernanke called…the fiscal cliff that’s coming at year end, with $500 billion worth of taxes and spending hits.  I think that’s really keeping a lid on the market.”

In March I posted some of my thoughts on future price behavior of the stock market and I have not changed my mind since then. (

However, I think that the European situation is also keeping retarding stock performance.

Two indicators I referred to at that time that seem to bear some relationship to the stock market performance are an index of financial market confidence and an index of financial market liquidity.  In early March, both indicators were pointing toward a stronger performance of stocks.  Both have weakened slightly since then…and these movements can be explained by events in Europe.

One such confidence index is published by Barron’s and is the ratio of the yield on Barron’s Best Grade bonds and the yield on Barron’s Intermediate Grade bonds.  A sign of confidence in the financial market occurs when this ratio goes up because investors are not requiring as big a premium in yields between these two grades of securities as were required before.  This is usually a good sign that investors are willing to commit to the financial markets.

This calculation can be duplicated using information provided on the H-15 release of the Federal Reserve where the ratio of yield on Aaa-rated bonds to the yield on Baa-rated bonds can be calculated.

In the March post I wrote “Last year this confidence index reached a near term peak in June and declined throughout the summer and fall until February of this year. It has since risen into the middle of March.  The earlier period coincided with a lot of uncertainty in the US economy and with the rising concern about the European sovereign debt situation. The pick-up in confidence came about as economic information seemed to improve and as the situation in the eurozone with respect to Greece improved.”

The Confidence Index hit a near term peak in late March as concern over the European situation rose in world financial markets.  This index still remains near recent highs.

The Liquidity Index measures how yield on US government debt compares with the yield on high-grade corporate debt.  Here one can go to the Federal Reserve release and calculate the ratio between the yield on 10-year US government issues and the yield on Aaa-rated corporate issues.  The higher this ratio, that is, the closer the Aaa-rated issues are trading relative to the government bond yield the more liquid the financial markets because money is flowing almost as easily into the corporate sector as it is into the most liquid market in the world, the market for US Treasury issues. 

In March I wrote, “The liquidity index dropped through much of 2011 and bottomed out in December. This index has been rising since then into the middle of March. The decline occurred because so much money went into Treasury issues from other issues in the financial markets, a “move to quality”. Over the past few months we have seen a reversal in this as funds have flowed back into these other issues making the market, as a whole, more liquid.”

Well, guess what?  With the recent buildup in concern over the financial situation in Europe, the “flight to quality” picked up again and vast amounts of money flowed into the US Treasury market.  This “flight to quality” also impacted the yield of German government debt.  The movement had little impact on other financial market yields.

In the middle of March 2012, the yield on the 10-year US Treasury bond was in the 2.25% to 2.40% range.  Now, the 10-year is trading in the 2.00% range.

In the middle of March 2012, the yield on the 10-year German bond was in 2.00% to 2.10% range.  Currently, this bond is trading in the 1.70% to 1.80% range. 

This “flight to quality” has impacted the Liquidity Index and produced a moderate drop in the relationship between government securities and high-grade corporate securities. 

There is a correlation between each of these measures and the money flowing into the stock market.  Right now, the Confidence Index seems to be holding its own, given the flows of funds in the financial markets, but the Liquidity Index has weakened. 

Given past experience, I do not expect to see the stock market to move ahead to substantially higher levels until we see some further resolution of the financial situation in Europe.  As long as the financial markets are focusing on “quality” and there is a remnant of the “flight to quality” remaining, stock market performance will remain relatively modest. 

So, I am agreement with Siegel on the future trajectory of the Dow Jones Industrial Average.  I believe that the Dow Jones will reach 15,000 by the end of 2013.  I believe that the economic situation can support such a rise. (See my post from March 30:

I agree with Professor Siegel that we have a fiscal problem in the United States that must be dealt with in some manner by the end of this year and that this is a concern of investors. 

However, I also believe that the European situation is impacting US stock performance and this will tend to hold back the rise of stocks until the European Union reaches a more complete solution.

In general, therefore, I am looking forward to a strong movement in the stock market over the next 12 to 18 months.   

Wednesday, April 25, 2012

More News on the Troubled Banking System: The TARP Report

Reports concerning the banking system keep popping up from time-to-time that continue to cause us to pause and wonder about the financial health of the banking system. 

We do not get information directly from the Federal Reserve System or the Federal Deposit Insurance Corporation about the state of commercial banks. 

However, we see that the Federal Reserve has pumped over $1.5 trillion in excess reserves into the banking system.  The Fed tells us that the quantitative easy that has created these excess reserves is to help spur on economic growth.  Yet, there still lingers a doubt about the real financial condition of the banking system and about the possibility that the Fed is keeping the banking system excessively liquid so as to keep banks, especially the smaller ones, afloat so that the FDIC can either close the weaker ones or assist others to merge into healthier banks in a smooth and orderly fashion. 

The FDIC, at last count, still had well over 800 commercial banks on its problem bank list.  So far this year the FDIC has closed about one bank per week.  The information we don’t have is the number of banks that have been merged out of existence this year.  Last year about five banks left the banking system every week either through being closed or by being merged out of existence. 

Now, Christy Romero, special inspector general for the Troubled Asset Relief Program (TARP), has released information indicating that “351 small banks with some $15 billion in outstanding TARP loans face a ‘significant challenge’ in raising new funds to repay the government.” (

This information was released in connection with her quarterly report to Congress. 

The total of $15 billion is not a small number.  If one looks at the FDIC statistics, as of December 31, 2011, there were 5,776 commercial banks that had assets of $1.0 billion or less.  The total of 351 banks only represents about six percent of the commercial banks of this size, but the $15 billion debt to TARP is approximately 12 percent of the Total Equity Capital of these banks. 

Why did these commercial banks need so much TARP money?  Well, the TARP money was supposed to provide liquidity relief to these organizations so that they would not have to get rid of underwater assets that would threaten their solvency.  They needed the TARP money because so many commercial banks had become “liability management” banks using purchased funds to support their asset portfolios. 

The only commercial banks that used to be “liability management” banks were the larger banks that could go into the money markets and purchase funds at market rates.  The larger banks purchased monies through the market for negotiable certificates of deposit and the Eurodollar market and similar other “liquid” markets.

Over the past twenty years or so almost all commercial banks, even some very small ones became “liability managers” as they used different forms of purchased funds to allow them to bid more aggressively for riskier assets or to grow faster than their local “communities” would allow.  Government agencies, like the Federal Home Banks even encouraged this behavior by making loans available to smaller banks…and thrift banks…so that they could grow and build their asset portfolios. 

I was just amazed this past year.  Given a bank transaction I was involved in I had the opportunity to take a webinar on Asset/Liability management offered by the American Bankers Association.  Within the material presented in this webinar was substantial information on how banks…small and smaller banks…could or should use purchased funds.  Not demand deposits or savings deposits supposedly the bread-and-butter of community banks, but purchased funds from outside the “community.”

Main Street was attempting to play the game like Wall Street!

This plays right into the TARP scenario.  These “smaller” banks were using purchased funds to support assets of different flavors and assortments.  As these assets dropped “underwater” and as the purchased funds had to be rolled-over, the banks, to avoid having to take losses by selling the assets, obtained TARP funds to allow them to keep the assets on their books.

This was exactly the purpose of the government troubled asset program.

Now, here we are a couple of years later.  The assets are apparently still underwater which means that the TARP funds cannot be repaid.  And, the banks are in such bad condition that they cannot even pay the quarterly dividends that are owed to the Treasury. 

According to the Report, in the first quarter of 2012, 200 TARP banks failed to make their latest payment.  The shortfall in dividend payments is $416 million!

So, we have some more evidence that the banking system is not “out-of-the-woods” yet in terms of its solvency issues.  Given this conclusion it is understandable that the Federal Reserve and the FDIC are aiming to err on the side of too much ease and very strict oversight.  One can guess that this posture will not end soon.

Furthermore, the bigger banks are just going to become a larger and larger part of the whole banking system.    

Tuesday, April 24, 2012

Banks Continue to Move Into the Future

Financial institutions continue to move ahead of those trying to keep up with them, the regulators, rating agencies, and investors. 

I have written quite a bit about this phenomenon in recent years.  Tracy Alloway, in the Financial Times the other day, gives us some more insight into what is going on…behind the scenes. Her article is titled “How Rewired Investment Banks Opt to Go With the Flow,” (

Banks are innovating and using technology to advance their cause.  The results are being seen in more and more areas within the banks and the consequences are now showing up in their reported financial results. 

Morgan Stanley, for example, posted an adjusted increase in fixed income, currencies and commodities (FICC) revenues.  “Other banks were also buoyed by their FICC business.” 

“The secret sauce of Morgan Stanley’s success, chief financial officer Ruth Porat says, was investment in new technology and fresh concentration on so-called ‘flow.’”

The definition of ‘flow’ is vague.  However, it has to do with ‘low margin business’ that ‘flows’ through the bank from customers’ orders and trading.  One aspect of this is that funding can seemingly come from almost any area of the bank.  Having these ‘vast amounts of flow’ at the banks’ disposal “gives you a lot of leniency to match order books, thereby saving on hefty financing costs.”

Banks with “the biggest balance sheets and heaviest customer flow” can dominate. 

This means that smaller players must be more imaginative in managing their ‘flows’.

But, this all requires the technology and the “know how” to make this happen…another benefit to scale.

The effort is aimed at ”matching inner streams and synergies.”

In other words, as I have discussed many times before, finance and financial flows are just information.   They are just 0s and 1s.  With sophisticated technology, these 0s and 1s can be carved up in almost any way you want to meet a need; they can be redirected to almost any place you would like them to go; and you can do this almost instantenously.

But, it is not just the cash flow side that can be impacted.  “One of the biggest levers that can be pulled within banks is expenses.”

“Technology has been invaluable here, with banks automating more and more of their traditional market-making activities.” 

Alloway argues that “if we learned anything from the swath of US investment banking results published this week, it should be that (the) client-facing, ‘front office’ model is not as important as it once was.  When deal volume is down, it’s what’s happening inside the big banks that counts.” 

“The difficulty” Alloway concludes, “is that much of the clever rewiring is taking place within banks—largely beyond the gaze of rating agencies and investors.”  And, one might add, beyond the gaze of the regulators.  

This technology is also impacting the customer side.  As I discussed last week in my post “Why Do I Need A Commercial Bank” (, financial institutions are evolving in a way that is rapidly changing the way individuals, let alone businesses, do their “banking.”  These developments mean that there is less need for the “classical” model of what a commercial bank does. 

Congress and bank regulators have worked very hard over the past three years of so in an attempt to make sure that 2008 doesn’t happen again.  By early 2009, as I was writing at that very time, financial institutions had moved ahead and, in my mind, were moving far in advance of where Congress and the bank regulators were.  I believe that the banks are even further ahead of Congress and the bank regulators now than they were then and the gap continues to grow.

This gap may be narrowed at some future time but it will never be closed.  Allan Meltzer proposed two laws of regulation in his book “Why Capitalism?” (Oxford University Press, 2012).  His first law of regulation: "Lawyers and bureaucrats regulate. Markets circumvent regulation." His second law of regulation: "Regulations are static. Markets are dynamic. If circumvention does not occur at first it will occur later."  

I have seen nothing in my professional career that would lead me to argue against these laws.   

Monday, April 23, 2012

Don't Expect QE3 From The Fed This Week

I just don’t believe that the Federal Reserve will step out this week with another round of quantitative easing.  The Fed meets tomorrow and Chairman Bernanke holds another press conference on Wednesday so we should hear about this soon.  

There are several reasons why I believe that monetary policy will continue along recent lines (

First, the economy is growing.  It is not growing as fast as some would like but it is growing.  It is not growing faster than it is because of structural problems in the labor market, in capital utilization, in housing markets, and in state and local government finance.  (  Due to these structural problems economic growth will not be robust over the next year or so, but will be in the 2.0% to 3.0% range.  The Fed can do little to speed up this growth. 

Second, loan growth has started up again in the commercial banking sector. ( Whereas this pick up will not contribute much to the economic growth mentioned above, I believe that it will produce some “down-side” protection against weaker economic growth.  The reason for this is that the loan growth will go into helping resolve some of the structural problems in the economy; it will not be going into producing more output and much higher employment.

Third, whereas the Fed has done about all it can to create more rapid economic growth at this time, it has also done as much as it can to protect the financial system against further shocks. There are still a lot of (smaller) commercial banks that have weak balance sheet positions but bank closures are only averaging about one per week this year, down from about three every two weeks last year and three every week in 2010. 

This, of course, does not include the assisted acquisitions and other mergers that are taking place.  We will have to wait until the FDIC releases first quarter results on the banking system to see how much smaller the banking system has gotten.  In 2011, 240 banks dropped out of the banking system, approaching five commercial banks leaving the system every week. 

The crucial thing is that the banking system is handling these adjustments smoothly and there seems to be no apparent reason that there should be any surprises in this area. 

Excess reserves in the banking system averaged above $1.5 trillion for the two banking weeks ending April 18.  There is still plenty of liquidity in the banking system.

Fourth, although there is much to worry about internationally, most of the “unknowns” are “known”.  Again, the thought is that even though Europe is facing a recession and there are some political changes that seem to be taking place in France (Sarkozy might not be re-elected) and the Netherlands (the prime minister has now resigned and new elections will be announced soon) that the continent will “muddle through” this mess and will continue to work toward some kind of fiscal union that will provide some more stability.  The fear, again, is of those “unknowns” that are “unknown.”  Surprise shocks are not wanted.           

Fifth, this is an election year in the United States.  As I have stated before, I believe that the Fed will try and avoid anything that makes it look like it is taking sides in the upcoming presidential election.  I believe that unless there is some kind of negative shock to the economic or financial system that is not on the radar, any effort to conduct another round of quantitative easing will be jumped on by the Republican presidential candidate and the Republicans in Congress.  To engage in QE3 at this time would bring down tremendous political criticism…on the campaign trail as well as in the Senate and House of Representatives. 

And, I believe that another round of quantitative easing would have little or no impact on the economy between now and the election in November.  As far as the Fed goes, the cost/benefit ratio does not favor more quantitative easing at this time.  Barring any unforeseen shocks, I believe that the trajectory of the economy is pretty well in place for the rest of the year.

Therefore, in terms of the new directive coming out of the Fed’s Open Market Committee meeting tomorrow and Wednesday, I believe we will just hear what we have been hearing over the past quarter or so.  At the end of the meeting, Chairman Bernanke will gather with the press and “make clear to us” that things have not changed.  For more on this see “Fed, Aiming for Clarity, Falls Short in Some Eyes.” (

Friday, April 20, 2012

It's About Debt, Stupid!

Much has been made during the recent economic recovery, which began in July 2009, about the excessive debt loads faced by small businesses and households.  The high debt levels have been given as a contributing factor to the economic collapse in the United States that appeared late in 2007.  In addition, these high levels of debt have been associated with the slow economic recovery

One of the major books published during this time period has been the work of Carmen Reinhart and Kenneth Rogoff titled “This Time is Different.”  The research presented in this book highlights the role that debt can play in the collapse of an economy and the subsequent slow recovery associated with debt-related economic crisis. 

Well, some good news is coming to us from the household sector.  It seems as if households are achieving some success in reducing their debt payments, which will allow them to continue to reduce their debt loads and increase their consumption expenditures.

“The Federal Reserve estimates that the household debt service ratio, a ratio of debt payments to disposable personal income, fell to 10.9% in the final three months of 2011 as a result of low interest rates and reduced debt levels.  That was the lowest reading since 1994.  Total financial obligations, which add in rent payment, homeowners insurance and property tax payments, were 16 percent, the lowest since 1984.”  This is an article by Floyd Norris in the New York Times ( 

Norris writes, “debt levels have fallen.  Over all, households owe about $13.2 trillion, nearly $600 billion less than in late 2008….low interest rates mean that servicing that debt costs less.  The Commerce Department says that mortgage interest payments, in dollars, are lower than at any time since 2005.”

Norris continues, “In this country, the deleveraging process has some way to go, with many foreclosures still pending….”  And, “To get the deleveraging process under way, it is important for lenders to race reality, admit losses and deal with them.”

Not all the reduction of debt has been voluntary: “”The McKinsey Global Institute estimates that about two-thirds of the reduction came from the cancellation of debt, through writeoffs and foreclosures.” 

Debt reductions, however, are debt reductions.  According to Reinhart and Rogoff, deleveraging is something an over-leveraged economy needs.

That is, these statistics are a positive sign. 

Furthermore, commercial bank lending has finally begun to rise.  This may sound contradictory to the above comments, but the crucial thing is that the bank lending is coming in areas that relate to business and not to the consumer and can be a positive contributor to economic growth.  In fact, this kind of loan growth is necessary for economic growth to be sustained, even if at a modest 2.0% to 2.5% rate. (See my post “Loan Growth Continues to Pick Up at Commercial Banks,”  I take this to be a good sign.

Finally, let me just add that I don’t perceive that economic growth will become robust for a little longer.  But, this does not mean that economic growth will not continue even at a tepid pace.  Analysts wring their hands over the latest numbers on the jobless claims and other recent indicators of the employment situation. (  The situation in the labor market is very worrisome.

However, the situation in the labor market is not just a short-run problem.  As I have pointed out numerous times over the past two years the un-employment rate is not the crucial one at this time.  The crucial indicator of the situation in the labor market is the under-employment rate.  I place this rate at around 20 percent of the eligible workers in the country.

There have been several articles recently in the daily press that discuss this point.  One of the better ones is “A Workforce on the Wane” in the Financial Times. (

Furthermore, it is not only in the labor market that we find an under-utilization of resources.  The capacity utilization in the manufacturing sector rests below 80 percent.  Before economic really begins to pick up in the future, businesses are going to have to deal with their surplus capacity, something that has steadily been growing since the 1960s. (

Dealing with under-employment and with under-utilization of capital is a long-run problem that must be dealt with over time.  The problem is, that as long as there are so many potentially productive resources out-of-line with what is needed in the economy, economic growth will remain slower than we would like it to be.  Re-training and re-structuring must be accomplished before higher growth rates can be sustained. 

The news on debt loads and debt levels is encouraging.  The direction begun must continue.  It is good that the commercial banks have stepped up this business lending for this is needed to underwrite the meager expansion that has already begun.  But, this is a long-term affair and efforts to try and get too much out of the recovery too soon will only make the future more precarious. 

Wednesday, April 18, 2012

US Treasuries Still a Safe Haven and the Yields on TIPS Remain Negative

International investors still flock to the United States Treasury bond market to keep their funds in a “safe place”.  As a consequence of this, interest rate relationships continue to be distorted.  Since early August 2011, the yield on the 10-year US Treasury bond has fluctuated somewhere around the 2.00 percent level. 

These declines occurred during the fall events that surrounded the fiscal problems in Greece.  The yields have remained at these low levels through the Greek restructuring and into the recurring concerns over the budget fights in Spain and Italy. 

The dramatic drop in the Treasury yield can be seen in the accompanying chart.  The 10-year Treasury was trading at or above 3.00 percent up until early August 2011.  Then the drop occurred.  And, the yield has basically moved around 2.00 percent since then. 

The interesting thing to me in this shift is what has happened to the yield on US Treasury Inflation-indexed securities.  They went negative in early August and, after bouncing around for a couple of months, dropped into negative territory again in early November and have stayed there since.  This can be seen in the chart below.  Yesterday the 10-year Treasury inflation indexed bond closed to yield a negative 0.31 percent.

The Treasury inflation indexed bond, since it was created, has served as a proxy for the “real” rate of interest.  It has varied a great deal more than one would like an “expected” real rate of interest to vary, but it, nonetheless has provided a benchmark that can be useful in analyzing what is going on in financial markets. 

Theoretically, the “real” rate of interest should be equal to the long-run rate of growth of the economy.  Over the past fifty years, a “rough” workable estimate for the real rate of interest was 3.0 percent, which was close to the compound rate of growth of real GDP from 1960 to the 2000s.

One could then get a “rough” estimate of the inflationary expectations built into interest rates by subtracting this estimate of the real rate of interest from a nominal rate of interest, the yield on the 10-year US Treasury bond.  Then one could compare the yield on the Treasury inflation indexed bond with these other measures in an attempt to understand what was currently going on.

In the current situation, one hard to support any proxy estimate for the “real” rate of interest.  The old estimates derived from the real growth rate of GDP seem useless given the current environment. (  And, the combined effects of the Federal Reserve’s quantitative easing and the “flight to quality” of the international investor have distorted market relationships.  That is, the past is not a good guide to the present interest rate relationships.

Rather than starting with an estimate of the “real” rate of interest, it seems that the place where one should begin is the nominal yield, the yield on the 10-year Treasury security.  Yesterday, the 10-year Treasury security closed with a yield of just about 2.00 percent.  The yield on the 10-year Treasury inflation indexed security closed at about a negative 0.30 percent. 

The difference between the two, about 230 basis points can be used as an estimate of the inflationary expectations of the market.  The year-over-year rate of increase in the price deflator for GDP was slightly about 210 basis points.  Thus, one could argue that the relationship between the yield on the 10-year Treasury security and the yield on the 10-year Treasury inflation indexed security…the proxy for inflationary expectations…was roughly in line with the actual inflation going on in the economy. 

One could then argue that the yield on the 10-year Treasury inflation indexed securities is negative because the flight to quality, along with the quantitative easing on the part of the Fed, has resulted in the yield of the 10-year Treasury reaching such a low level.  That is, the Fed’s actions along with the European financial crisis has distorted interest rate relationships to the point where we actually have some market interest rates that are negative.  The inflation-indexed security bears a negative yield because investors still must consider how actual inflation will impact the nominal returns they receive on their bonds.  Given the inflation that is expected by the market and given the current level of yields on “risk free” securities, the “real” yield in the market place can be no where else but in negative territory. 

Here, then, is a way to interpret the extent of the financial upheaval going on in the world.  If the yields on the Treasury’s inflation indexed bonds remain negative or extraordinarily low, then one can assume that the risk-avoidance going on in the world is still quite high.

Tuesday, April 17, 2012

Economic Growth Will Continue: Entering the Next Stage

I continue to be more optimistic about the path of economic growth that is occurring in the United States.  There are still potential “bumps-in-the-road” like the recession in Europe ( and the slowdown in the economic growth of China.  Still, the economic recovery in America goes on.

On the positive side, I am encouraged by the fact that bank lending is getting stronger. ( The important signal, to me, coming from the banking data, is that the health of the banking system is improving.  Although many commercial banks still have major problems, the system, as a whole, is getting stronger and this is allowing for greater loan growth.  In the first quarter of 2012, the annualized rate of growth in loans and leases at commercial banks was almost 6.5 percent.  This is good.

Today, we got some encouragement from the housing industry: “Building permits in March 2012 were at a seasonally adjusted annual rate of 747,000, up 4.5 percent from the revised February rate and up 30.1 percent from March 2011. Housing starts in March 2012 were at a seasonally adjusted annual rate of 654,000, down 5.8 percent from February’s revised estimate but up 10.3 percent from March 2011.”  The decline from February to March was due to unseasonal strength in the housing area because of the very mild winter weather experienced this year.  The year-over-year rate for March is much more indicative of the pick up in this construction.

The economic recovery is continuing. 

On the negative side, I still believe that economic growth will continue to be anemic compared with historical trends.  As I have argued before (, I am expecting economic growth to be in the 2 percent to 3 percent range, but I believe growth will be closer to the former figure than the latter.

There are several reasons for this.  One reason is that under-employment will still remain high.  I don’t care that much about un-employment in the current case because under-employment has remained in the 20 percent range and as long as this condition exists in the United States, consumer spending will remain relatively weak.  Furthermore, this condition just adds to the pressure for families to deleverage and get out from under the debt loads they have been carrying.  This helps to account for the very weak consumer loan data at commercial banks.

There are also other reasons for only moderate economic growth.  State and local governments still have a ways to go before they become a positive force in the economy again.  With declining property values and huge problems in the pension area, these governmental bodies will continue to slash payrolls and other budget items in an effort to return to some form of fiscal prudence. 

And, there is one other area that I believe will continue to weigh on the economy over the near future.  I have written from time-to-time about the impact the last fifty years of credit inflation has had on the productive capacity of the United States manufacturing base.  Credit inflation is not good for producing improvements in the productivity of capital.  And, if the productivity of capital is not increasing then economic growth is going to suffer.

The effects of this credit inflation are picked up in the utilization of our productive capacity.  In the 1960s, capacity utilization in the United States was well in excess of 90 percent.  There has been a secular decline in capacity utilization in America as the peak of every business cycle over the past fifty years has been at a lower utilization of our capital base. At the last cyclical peak we were using slightly more than 80 percent of our capacity.  At the present time capacity utilization is increasing as the economy has expanded since June 2009, but we remain around 78 percent. (The March figure of capacity utilization of 78.6 percent was released this morning.)

I believe that the economic growth rate of the United States will remain below the post-World War II level of about 3.2 percent as the rate of capacity utilization continues to lag.

The problem with this is that this growth rate will not accelerate as potential inflation problems arise. 

This inflation problem is raised by Francesco Guerrera in the Wall Street Journal: “Sowing Seeds of the Next Major Crisis.” (  For one, the Federal Reserve has pumped massive amounts of reserves into the banking system.  This was done to protect against a greater financial crisis than was experienced and to prevent the banking system from collapsing.  The post-crisis problem is about the ability of the Fed to remove these reserves from the banking system without jump-starting another crisis. But the question is, if the commercial banks have all these excess reserves (about $1.5 trillion of them) and if the banks are beginning to lend again, where is all this money going to go?   

If the economy will not grow much faster, the answer is that the money will force up prices.  These are not “normal” times.  As Guerrera states, “Unfortunately, there is little ‘business as usual’ around. Not at a time when Europe is in recession, the U.S. in the throes of an anemic recovery and even China is slowing down. And not when bank balance sheets are saddled with decaying leftovers of the crisis—asset-backed securities, bad loans and litigation—and vital parts of the system, such as derivatives trading, are gummed up by fears of new regulations.”

This scenario has “stagflation” written all over it.   The economy will continue to grow, but maybe we should start to prepare for our next series of problems.

Monday, April 16, 2012

Loan Growth Continues to Pick Up at Commercial Banks

My report on bank lending last month had the headline, “Finally, some real loan growth at the banks.” (

Well, loan growth has continued through March.  Loans and leases at commercial banks increased by over $10 billion in March, bringing the total rise in loans and leases up to $95 bullion for the first quarter. 

The interesting thing is that this increase occurred predominately in the “small” banks in the country, the roughly 6,265 banks that comprise the Federal Reserve’s definition of small.  The “large” banks are the largest 25 domestically chartered commercial banks in the country.  A total of $79 billion, or, 83 percent of the increase in loans and leases at commercial banks in the United States over the first quarter, came from these “smaller” banks. 

This is certainly good news.  Economic growth in the United States had been rising since June 2009, but the growth rate has been pretty tepid.  Two reasons for the slow growth were that many individuals and businesses in America were deleveraging and the commercial banking system was trying to get itself in order given all the bad assets that were on the balance sheets of the banks. 

The concern has been that as long as the banks were re-structuring and individuals and businesses were attempting to lessen the debt on their balance sheets, economic growth would remain shaky.  For things to feel more secure, banks would have to start lending again. 

Loans and leases at commercial banks were up 4.7 percent, year-over-year, in March.  Almost two-thirds of this growth came in the past six months, and over one-third of the growth came in the last three months.  This is encouraging.

In the smaller commercial banks, the largest increase in loans came in the residential real estate area.  Residential loan growth rose by more than $31 billion in the past quarter and about $53 billion in the past year. 

The interesting “turn-around”, however, was in commercial real estate loans.  For the year as a whole, commercial real estate loans at the “smaller” banks were down by almost $13 billion, but, for the last quarter they were up by more than $14 billion, a $27 billion reversal. 

Commercial real estate loans were still down in the largest 25 banks by over $5 billion in the quarter, but on the whole, the strength shown in this area is ‘hopeful” and worthy of continued watching.

Business loans at commercial banks (commercial and industrial loans) have been up year-over-year for several months now, but the real strength has been at the largest banks.  For example, year-over-year, commercial and industrial loans at the largest 25 banks in the country were up by almost $105 billion compared with an increase of $42 billion at the smaller banks. 

However, in the first quarter of 2012, business loans at the largest banks rose by $25 billion as compared to a $24 billion increase in the “smaller” banks. 

This, to me, is a good sign for economic growth.  Although it may not translate immediately into much faster growth, I take this strength in lending as protecting against a downside fall-off.

Consumer lending was particularly weak in the first quarter of 2012 as consumer lending fell by more than $2 billion.  This would seem to indicate that consumers were still consolidating and/or reducing their debts and were not out spending.  This, of course, can help to account for the continued weakness in economic growth. 

Overall, the information coming from the banking system is encouraging.  Commercial bank lending is increasing and it is increasing in both the business and real estate sectors of the economy.  Furthermore, bank lending is showing more strength amongst the “smaller” banks in the country.  This is good news to me not only because it might indicate that “main street” is beginning to show some life, but this could also be an indication that the health of the “smaller” banks is improving. 

One final point has to do with the cash balances carried by the commercial banks.  In March 2011, commercial bank cash holdings averaged $1,443 billion.  In March 2012, cash holdings averaged $1,594 billion, up $151 billion for the year.  Commercial banks are still carrying a lot of cash on their balance sheets.  (According to Fed statistics, excess reserves in the commercial banking system averaged $1,362 billion in March 2011, and averaged $1,510 in March 2012.)

However, this cash figure for March 2012 is down from the $1,838 figure of September 2011.  So, commercial banks are holding less cash now than they were at certain times last year. 

One reason for this is that foreign-related institutions are holding a lot less cash than they were last year.  In September 2011, these institutions held almost $1.0 trillion in cash assets.  In early April 2012, this figure was down to about $650 billion.  A large portion of these assets were lent out to “related foreign offices” of the foreign-related institutions.  From March 2011 to a peak in February 2012, roughly $285 billion flowed from these foreign related institutions to their “related foreign offices.”  These flows were closely connected with the financial problems being faced in Europe.  With the efforts to resolve the debt crisis in Greece and with the lending down by the European Central Banks, the needs for cash from the United States lessened.  Lending to “related foreign offices” fell by almost $90 billion between early February and early April as the pressure from the crisis in Europe receded. 

We are not yet out-of-the-woods in terms of the problems in Europe and in terms of our need for stronger economic growth in the United States.  However, particularly concerning the latter, I feel better now that commercial banks seem to be producing more loan growth.   We can only hope that this loan growth will continue to modestly expand.  

Tuesday, April 10, 2012

Why Do I Need a Commercial Bank?

There is really no reason for me to be a customer of a commercial bank. 

Full disclosure: I am not the customer of a commercial bank. 

There is really little or no reason for many people…and businesses…and non-for-profit organizations…to be a customer of a commercial bank.

Here again, however, we are getting a bifurcation of the society. 

The world is splitting into those people, people with even a modest amount of wealth and some financial sophistication, who do not really need a bank and other people, who need only the very basic products and services offered by some kind of a banking organization.  And, in the latter case, a credit union is often the best place they could go to get the kind of products and services that they need.

Pushing this split along is…of course…the regulators. 

Allan Meltzer, in his delightful little book “Why Capitalism?”(Oxford University Press: 2012)   presents his two laws of regulation.  His first law of regulation: “Lawyers and bureaucrats regulate. Markets circumvent regulation.  His second law of regulation: “Regulations are static.  Markets are dynamic.  If circumvention does not occur at first it will occur later.”  The regulators, in their attempt to prevent a recurrence of 2008, are pushing the financial system well beyond what it once was.

Furthermore, advances in information technology are making circumvention easier and easier every day.  If finance is just information…which it is…and information can be presented in any form that can be useful, then financial information can be “sliced and diced” in any way that can serve the needs of a person or an organization.  And, it can be done almost instantenously.  This certainly will contribute to the ability of financial institutions to “circumvent regulation”.

The Financial Times devotes two pages in its April 10, 2012 issue to “shadow banking.”  To include the scope of this area, the Financial Times lists “alternative forms of finance.”  These alternative forms include leveraged finance, broker-dealers, hedge funds, money market funds, insurers, blue-chip lenders, mortgage servicing, peer-to-peer lenders, and governments. 

The paper even has a case study of what Siemens is doing to protect its money and to provide credit to suppliers as well as customers.  And, Siemens operation has been expanding over the past five years, rather than shrinking like many other “banking” organizations and now has a presence in such emerging markets as China, India, and Russia. 

Even Vikram Pandit, the chief executive officer of Citigroup, a form hedge fund manager, has stated that “One of the many unintended consequences of the brutal regulatory crackdown on banks is that there is now a massive incentive to be a shadow bank.”

But, there has also been a massive shift in terms of what is available to individuals and families on the financial front.  If you would have told be a few years ago that I would have no need of a commercial bank I would have said that you were delusional.  Now, as I said above, I do not do my “banking business” with a commercial bank. 

And, the situation is becoming even more desperate for the commercial banking industry.  The American Bankers Association is frantically fighting legislative bill S. 2231 which contains legislation that would allow credit unions to more than double the amount of business loans they could keep on their books.  The ABA argues that a vote for this legislation is a “vote against your community banks.”  ABA material goes on to say that “This special-interest bill allows aggressive credit unions to leverage their tax advantage to steal loans from community banks.”

It could be noted that credit unions are not taxed because they are mutual organizations…like mutual savings banks and savings and loan associations before them…but also have a lower cost structure that adds to their ability to attract business. 

The financial industry is changing and is changing dramatically.  Technology is speeding this change along, but so is regulation.  It is obvious that the press is now very aware of the innovations that are taking place.  More and more we see articles on mobile banking, new financial instruments being formed, products and services being offered in a different way, and global organizations penetrating more and more into regional and local banking markets. 

More and more people I talk with do not keep their business at a commercial bank any more.  Most of the young people (in their teens) I know are so sophisticated technologically that it is ridiculous to think that they will have anything to do with commercial banks.  And, if that is true, what will the case be for their brothers and sisters that are only five, let alone ten, years younger than they are?

The American Bankers Association admits that “Community banks account for a little more than 10 percent of the banking assets in our country….”  I cannot envision a scenario in which this percentage will increase…even if the credit union legislation mentioned above is defeated. 

In fact, I cannot envision a scenario in which the larger financial organizations do not become more and more like “shadow banks” rather than commercial banks.  Global competition will demand it.