Thursday, August 23, 2012

Money Market Mutual Funds and Shadow Banking

Wednesday, the Securities and Exchange Commission cancelled a plan to vote on imposing new regulations on money market mutual funds.  Although SEC Chairwoman Mary Schapiro, with the backing of the Federal Reserve chairman and the Treasury secretary, supported new measures, she backed off from actually holding the meeting when the swing vote stated that he could not, at this time, support the new regulations. 

Money market mutual funds are not banks, but account holders can write checks against their accounts.  Account holders are promised that they will get $1 back for each $1 share that they own.  However, there is no deposit insurance connected with the accounts.

Money market mutual funds can invest in risky securities and need hold no capital on their balance sheets to absorb any losses that the fund may experience.  In 2010 the SEC introduced new rules to achieve more stability in the industry, the most important one being a rule that required fund managers to hold more assets that could be easily sold so as to be more liquid in the case there was a significant increase in withdrawals from the funds. 

Money market mutual funds evolved from the 1970s and are part of the shadow banking system.

The attempt to increase regulations on money market mutual funds is just one effort being made to regulate the shadow banking system.  The Dodd-Frank bill is, of course, the driving force behind most of these efforts.

The industry fought a hard battle against Schapiro, and, for the time being, has stemmed the tide of new regulation.

On the industry side, the argument is that the rules introduced in 2010 have proved sufficient and are enough to protect the industry from future problems.

The other side argues that since most money market mutual funds lend to the same borrowers, the industry is subject to systemic risk because of the failure of one or more borrowers.  The concern over the possibility that something like this could happen increases the probability that in a time of financial stress, account holders could get “spooked” and this would cause a run on these institutions.

Ms. Schapiro had suggested that the SEC impose one of two possible options.  First, let the value of the accounts vary with the market value of the funds’ holdings.  Or, two, require the funds to hold capital to absorb losses.  In other words, she wanted to make these institutions into something out of the past.   

The private-side backup to the problem of capital is that the “sponsors” of these money market mutual funds will provide money to the funds should the assets of the funds be threatened.  In fact this is what happened in the recent financial crisis where, according to the article referenced above, companies that sponsored money funds had to help the money funds out: “At least $4.4 billion was provided between 2007 and 2011 to at least 78 funds.”

The question then becomes: will the sponsors always be there?

Although helping the funds out would seem to be in the interest of the sponsors over time…no one can really claim to know the answer to this question.

But, the discussion surrounding this issue for the money market mutual funds can be extended to almost any area of the banking industry as well as to the shadow banking industry.  Let me just take up another subject for a minute, the trading of swaps.  We are told that: “When US regulators, (thanks to the Dodd-Frank Act) led by the Commodity Futures Trading Commission, move to vote on swap execution rules later this year, the industry fears an overly prescriptive approach that could push trading towards that of listed futures or equities. In these largely electronic markets, trading is more frequent and the size of trades is much smaller than the notional hundreds of millions transacted in OTC derivatives.”
In anticipation, the banks that act as big swap dealers are tackling their cost base, investing in more technology and adjusting to the prospect of using less leverage, taking less risk and by extension harvesting smaller bonuses.”  These changes will tend to raise costs, reduce revenues, and change the way that business is done.
However, the technology in this area is already changing with the leaders being Goldman Sachs, Morgan Stanley, and UBS.  The resulting model will be more like an exchange-traded model.  The instruments traded will be more homogeneous and, as one analyst stated, “we’ll employ our equity tools and slice and dice orders, so they’ll become smaller” and traded more rapidly and will spread to more firms and smaller firms.  That is, financial innovation will adapt to the situation.
This kind of world, as we have seen, becomes more complex, more interactive, and moves at faster and faster speeds. 
As I have written many times before, the regulators cannot keep up with this world, the regulators cannot fully understand what they are dealing with, and the regulators will not be able to prevent the next…or, any future…financial crisis.
The world we are in…and the world we are moving into…cannot be comprehended at this stage because we cannot predict what the evolution of electronics and information technology will bring.  What we can say about this future is that the private sector institutions will find the incentives and invent the ways to get around just about anything that the regulators want to place in their path. 
I believe that in the case of money market mutual funds, causing these institutions to either allow their accounts to vary with the market value of their assets or to impose capital requirements on the institutions will result in customers moving elsewhere in large numbers to institutions that will guarantee them the value of their initial deposits or will cause firms to find another way to do their business because the capital requirements raise the cost of doing business too much.
If rules like these are imposed on the industry, then another kind of financial institution will evolve to provide customers with the account guarantee they want as homogenously as possible.  That is, as with the potential future of the swap market, financial institutions will evolve that will employ equity tools to “slice and dice orders” into any form the customer the cheapest cost. 
The regulators, in my mind, still don’t understand the environment they are working within.  The modern credit engine can turn a cash flow into almost anything imaginable.  After all, finance is just information.  Applying alchemy to the finance system to make it into something the regulators want, will not work.  The regulators must “get real” and accept the world for what it is.  The regulators must attempt to build processes that help the system adjust and focus less on outcomes, which cannot be achieved.    
The financial world is changing.  Electronics and information technology is going to allow finance to do things we can’t even imagine.  Efforts by the regulators to force people and institutions into something that used to exist will not work, yet, they will keep on trying.  Since the regulators will not change, what we need to do is to look for opportunities that take advantage of the dislocations that the regulators create and take advantage of them!         

Wednesday, August 22, 2012

Treasury Discounting TARP Advances to Small Banks

On May 4, I posted a blog that discussed the fact that the United States government…us…will probably have problems getting TARP money back from smaller commercial banks.  In that post I reported the following:

“’Most small banks bailed out by US taxpayers during the financial crisis are unlikely to be able to repay the Treasury department, the Obama administration says.’ (

This came out in a blog post on the Treasury’s website yesterday. See “Winding  Down TARP’s Bank Program,” by Timothy Massad, assistant Treasury secretary for financial stability. The Treasury does not expect “the majority of the nearly 350 lenders still partially owned by US taxpayers to repurchase in the next 12-18 months the preferred stock that Treasury received in exchange for bailing them out.”
The “smaller” banks are defined as those with less that $10 billion in assets.”

Well, currently the Treasury Department is trying to speed things up in an attempt to bring the TARP to an end for the commercial banking system.  The word on the “street” is “The current administration is very motivated to unwind its crisis-related investments.”  This from Compass Point Research and Trading, a broker dealer that has been analyzing recent TARP auctions.

The translation of this from Jesse Eisinger of the New York Times is: “The world has moved on, and the Obama administration seems to be counting on being able to run down the program as quickly as possible without too much scrutiny.”

But, this is nothing new.  As reported in my last post, when the government gets involved in the private sector, the list of objectives on the government’s “to-do” list is not always the same as the list of objectives of a private institution…or of taxpayers. 

In this post I discussed the bailout of the General Motors Corporation, which resulted in the US government becoming roughly 75 percent owners of Ally Financial, formerly known as General Motors Acceptance Corporation (GMAC).  For more on this case go to my blog, because the only important point from that blog for today’s discussion is the quote that, “The government apparently believes that it cannot wait because the outcome…is uncertain and working out’ the (problem) would take an extended period of time. ‘When the government is your lender, paying back the money is your first goal.’”

In other words, the Obama administration wants to get the financial crisis behind it as soon as it can regardless of what the cost of an early exit might be.

The outcomes discussed in the article relating to the commercial banking situation and in the article relating to Ally Financial are that the government is leaving cash on the table as it seeks the exit door.

In the case of the commercial banks, the Treasury Department is not getting back 100 percent of each dollar advanced to the banks.  And, this includes banks that have “strong profits and strong capital positions.”  That is, even healthy banks are not paying back 100 cents on the dollar.

The New York Times article cites four specific cases: “When the government sold its holdings in MetroCorp Bancshares of Houston this month, the bank itself bought back most of it—at 98 cents on the dollar.  Wilshire Bankcorp of Los Angeles bought back its paper at 94 cents on the dollar.  The Treasury Department sold preferred shares of Ohio-based First Defiance at 96 cents, and Peoples Bancorp of North Carolina at 93 cents.  All of these are regarded as healthy.”

The big banks paid back 100 cents on the dollar.

But, the question still outstanding is the discount the government will have to take on the banks that are less than healthy.

The issue is not so much that the bank bailout program is going to cost the government money.  So far the bank portion of TARP has been profitable with the Treasury estimating that it will make almost $22 billion from the bank support programs.  Even if the money coming back into the Treasury is not 100 cents on the dollar, the shortfall will not use up all that has been already received. 

The primary issue is that the discounts are going to reduce the final amount that will have been returned to the Treasury and the faster officials try and bring this part of the program to a close, the less taxpayers will have to show for the government’s effort. 

But, as my previous post discussed, this is one of the problems with many government programs.  The ultimate objectives of the programs run by the government are not the same as the objectives that a private organization would seek.  As a consequence, these government programs tend to leave something “on the table” for the well positioned, the well informed, and those with the resources to walk away with.

Nothing illegal here…it is just the way governments work.

And, who seems to be “walking away from the table” with icing in this case?

Note that the examples given above all relate to “healthy” banks…those that have “strong profits and strong capital positions.”  But, time is money and the government apparently is willing to give up money in order to get paid back sooner rather than later.

Still, this leaves a big question open.  What about the banks that are not healthy?

In the earlier Treasury report, the author stated that there were 350 banks that remained “partially owned” by the federal government.  In the current New York Times article, Mr. Eisinger states that the discounts that may have to be taken could result in further taxpayer losses “in the hundreds of millions.” 

But, take off a dozen or so healthy banks from the 350 number and you still have a substantial number of banks partially owned by the government that are in various stages of “not very good health.”  What is our problem here?  How many of these banks are seriously impaired? 

There are still a lot of commercial banks in the banking system that are not in very good health.  As of March 31 there were 772 FDIC insured banks on the list of problem banks. (We will get the number for June 30 this week as the FDIC releases these numbers 55 days after June 30.)  How many of the banks that owe the government TARP money are on the problem list?

There have only been 40 banks closed this year through last Friday.  It appears that many more banks are merging out of existence than are closing outright.  In the first quarter alone the number of banks in the country dropped by 50 units even though there were only 16 bank closures. 

The point is, the banking system is still not back to “good health” yet and the TARP numbers, the bank closure numbers, the fact that the Fed still has injected over $1.5 trillion in excess reserves into the banking system just confirm this fact.  Things continue to get better, but I believe that the system is still somewhat fragile.  This is one reason why many banks are not growing their loan portfolios.  We just continue to hold on and hope things will continue to improve.    

Does Warren Buffett have an Ally?

My post of Monday August 20 closed with the following comment: “as one reads a book like ‘More Money Than God’ by Sebastian Mallaby, one observes that lots and lots of money is made off of government mistakes. The problem is that generally the people that make the money off of these mistakes are people that have the information, the access, and the scale to take advantage of the mistakes. However, these "tools" are not available to most people. Maybe that is why the distribution of wealth in the United States has become so skewed.”

Well, Steven Davidoff of the New York Times gives us a perfect example of this type of situation as he discusses the evolving consequences of the government bailout of General Motors.

Let me just say before we get started that “government mistakes” can be split into two categories.  The first relates to overt government mistakes like the British government trying to maintain an un-maintainable price for the British Pound in the 1990s.  The result was the classic case of George Soros laughing all the way to the bank with billions of dollars.

The other type of mistake has to do with “unintended consequences,” the result of government action that may occur because the government either does not have the incentive to totally examine the results of what it is doing or the government does not have the same goals and objectives of the private investor. 

An “unintended consequence” gets this story started.  Davidoff sets the scene. “G.M.A.C (General Motors Acceptance Corporation) was the financial arm of General Motors.  In the years leading up to the financial crisis, it was also G.M.'s most profitable unit, which tells you something about the auto industry at the time. The company earned more profit from lending money to customers than in selling cars.”

Why did G. M. A. C. become “G. M.’s most profitable unit”?

Well, in the 1960s, the US government was very concerned with rising unemployment.  In an attempt to keep unemployment as low as possible, the government established a policy of credit inflation to keep workers employed.  The justification was something economists called “the Phillips Curve.”  The Phillips Curve encouraged the government to inflate the economy because there was a tradeoff between inflation and unemployment.  A little more inflation could buy the government a little more employment thereby keeping the unemployment rate down.

Milton Friedman showed this argument to be a fallacy because a little more inflation got built into inflationary expectations and this worked in the opposite direction of lowering unemployment.   However, politicians got stuck on the first point and, in order to get elected or get re-elected, they (both Republicans and Democrats) they continued on with a policy of credit inflation into the 21st century.

Inflation, however, changes incentives.  As I have written many times before, inflation results in people and businesses taking on more risk, taking on more financial leverage, mismatching the maturities of assets and liabilities, and introducing more and more financial innovation.  And, people make lots and lots of money off of betting with inflation!

General Motors did this through G. M. A. C. and the subsidiary became “G. M.’s most profitable unit.”  But, General Electric also did this and more than half the profits GE earned came from its financial wing.  And, this was true of other “major” US corporation.

Yes, people were kept employed but General Motors did not have to focus on productivity or labor skills or “selling” cars, could focus on keeping its labor unions happy with “good” labor contracts, and, as an unintended consequence GM became uncompetitive.  But, GM executives benefitted greatly from the profits now coming from the financial side of the business.

I won’t go deeply into the situation described by Mr. Davidoff because he does an very good job at explaining what is going on.  What is important is that what is going on is a result of another “unintended consequence.”  The government’s objective in resolving the bailout as the Treasury Department stated was “to exit in in a manner that balances speed of recovery with maximizing returns for taxpayers.”

And, as Mr. Davidoff goes on to explain, “That’s the problem with companies being bailed out.  They’re no longer as entrepreneurial or risk-taking as they might be, and instead have to balance gains against a need to pay back the government.” 

The situation: G. M. A. C. became Ally Financial.  But G. M. A. C. was not just about financing automobiles  “The company was also one of the largest subprime housing lenders through its ResCap subsidiary.”   ResCap is the fifth-largest mortgaging service and origination unit in the nation. Thank you, credit inflation!

ResCap has lost billions during the Great Recession and Ally has subsidized this loss lending ResCap $1.2 billion and also infusing $10.2 billion into the subsidiary since January 1, 2007.

That is, until recently.  Ally Financial put ResCap into bankruptcy.

And, here we get to Mr. Buffett.

In the bankruptcy of ResCap, the company was to split up into two parts, one part consisted of the mortgage servicing and the other part was a legacy portfolio of mortgages with $5.2 billion in loan principal.  Ally initially “announced its intention to serve as a stalking horse bid for the legacy portfolio, bidding from $1.4 to $1.6 billion.” 

Ally has now dropped out.  Guess who showed up?  Berkshire Hathaway…which, by-the-way is one of Ally’s biggest creditors.  Berkshire has now replaced Ally as the “stalking bidder” for the loan portfolio. 

Although the outcome of this bidding will come in bankruptcy court auction, Ally will not be a part of the bidding: Ally, which has lost billions of dollars in the portfolio.  And, they leave just at a time when there is some indication that the housing market might be getting stronger so that there seems to be a growing possibility of getting something more back from the loans.

And, the government apparently believes that it cannot wait because the outcome of acquiring the loans is uncertain and “working out” the loans would take an extended period of time.  “When the government is your lender, paying back the money is your first goal.”

So someone in the private sector stands to gain a lot of money from this transaction.  And, that “someone” is not the “small person”.

As I stated in the August 20 post, “generally the people that make the money off of these (government) mistakes are people that have the information, the access, and the scale to take advantage of the mistakes. However, these ‘tools’ are not available to most people.”

As Mallaby suggests in his book, these returns are “alpha” returns, returns that are not dependent upon the movement of the whole market.  Governments, acting on the best of intentions, seem to create a relatively large number of these “alpha” opportunities.  And, they are not kept a secret and they are legal.  Our job is to look at what the government is doing and determine what are the “unintended consequences” of the government’s action and then take advantage of it.   

Mr. Buffet and Mr. Soros seem to be good role models for us to follow.       

Monday, August 20, 2012

Is the Bond Market Showing Confidence These Days?

Barron’s publishes a ratio that it calls a “Confidence Index.”  The Confidence Index is derived by dividing Barron’s index of Best Grade (corporate) Bonds by Barron’s index of Intermediate Grade (corporate) Bonds.

According to this paper, if the intermediate grade index falls relative to the best grade index it represents a sign of market confidence because the intermediate grade bonds are not requiring as much of a yield spread as in the past and this means that investors are more confident.  The paper suggests that this “generally indicates rising confidence, pointing to higher stocks.”

Well, Barron’s Confidence Index hit a near term low in the week ending July 27 and has been rising since.  The implication of this movement is that, potentially, the stock market should rise.

Note: One can use the yields on Moody’s Aaa- and-Baa rated industrial bonds published in Federal Reserve release H.15 and get a similar result.  

Since August 3 the Standard & Poor’s 500 Index has risen about 2 percent from 1390 to 1418.

Defining the confidence index in this way makes some sense since when financial market conditions are improving the yield on intermediate grade bonds tend to fall faster than does the yield on the best grade bonds causing the confidence index to rise. 

Conversely, when confidence is being lost in the bond markets, yields on intermediate grade bonds rise faster than do the yields on the best grade bonds.

This is what happens in a “normal” cyclical situation.

However, the past several months have not been normal.

Barron’s Confidence Index has been rising because the yield on the Best Grade Bonds has been rising relatively more rapidly than the yield on Intermediate Grade Bonds. This is also true of the movement in the yields on Moody’s Aaa- and Baa-rated bonds.

This is not the way it is supposed to be. 

The difference is the fact that the United States bond markets have been a “safe haven” for funds from around the world.  The flow of funds into United States markets have distorted interest rate relationships.

The question is…does this distort the interpretation one gives to Barron’s Confidence Index?

The international money really started pouring into the United States in early May.  The yield on the 10-year Treasury issue broke 1.90 percent on May 8.  Barron’s confidence index reached a near term high in the week ending May 25.  Moody’s numbers actually achieved the near term high in the week ending May 5.  Both measures of “confidence” fell until the week ending July 27 as mentioned above.

In this case, the confidence index fell because of all the foreign money flowing into the United States to seek the “safe haven”.  Yields on US Treasury securities fell very rapidly, but also the best grade of corporate bonds also gathered in some of these funds and the yields on the best grade of bonds fell relative to the yields on intermediate grade bonds.

Confidence in the United States bond market was increasing while Barron’s Confidence Index was showing a loss in market confidence. 

The stock market dropped off soon after this “fall in confidence” with the S&P 500 index dropping off from about 1360 on May 8 and reaching a trough of approximately 1280 at the end of May.  However, as related earlier, the S&P 500 was around 1390 by the first part of August, a rise of slightly more than 8.5 percent.  The rise from May 8 to August 3 was a little more than 2 percent. 

The argument for the immediate decline in the stock market in May was the fear connected with the deteriorating situation in Europe.  After the initial decline in the stock market, “confidence” in the US stock market seemingly came back…although the variation in stock market movements seemed to be rather high indicating the uncertainty connected with what was happening in Europe.

So, when Barron’s Confidence Index dropped off in May the stock market also fell.  From the end of May through the end of July, Barron’s Confidence Index continued to fall while the stock market rose.  So, we have some conflict here.

Another ratio using similar data can also be used in situations like this.  It is called the “Liquidity Ratio” calculated by dividing the yield on 10-year US Treasury bonds by the yield on Moody’s Aaa industrial bonds.  A higher ratio is shows that the financial markets are “more liquid” since the ratio of yields is narrower…funds are getting into the Aaa market as well as into the government market.   

The “liquidity ratio” peaked out this year in the same week as did the “confidence index” using Moody’s numbers.

However, the “liquidity ratio” hit a bottom around the same time that the S&P 500 index was hitting the near term bottom in late May.  This would indicate that some of the “safe haven” funds coming into the Treasury market began to spill over into the high grade corporate bond market…the financial markets were becoming “more liquid” due to the funds attempting to achieve higher yields without much loss of quality. 

Thus, the stock market began to rise again in June as confidence rose on the “liquidity” of the financial markets, even though the liquidity had not flowed as far as the intermediate grade instruments. 

It was not until late July that more and more funds moved into Baa or intermediated grade bonds and Barron’s Confidence Index started to rise again…along with Moody’s numbers. 

The “liquidity ratio continued to rise through to the present so that for the last several weeks we have had both the “confidence index” and the “liquidity index” giving off similar signs. 

Note, however, that the yield on the 10-year Treasury yield has been rising over the same time period, reaching its lowest level on July 25…1.43 percent.  Currently, the 10-year Treasury is yielding over 1.80 percent. 

The last several months, therefore, have been an interesting time period.  The movement of international funds into the United States has caused some financial market relationships to be distorted.

Still, it is important to work with the data and see if events can be explained by including more information in one’s analysis.  Historically, the “confidence index” information has moved in the same direction as the “liquidity index” information.  When they differ it is important to try and reconcile why they might be moving in different directions.  In the current situation, I believe that looking at the two ratios helps us to understand a little bit better what has been going on. 

Right now, the bond markets are reflecting market confidence and market liquidity, both of which are positive signs for a rising stock market. 

Sunday, August 19, 2012

The Setting for Ben Bernanke's Speech at Jackson Hole

Anticipation is rising for the annual late summer speech given by the Chairman of the Board of Governors of the Federal Reserve System, Ben Bernanke.  The basic economic environment surrounding this speech is what I would like to touch on in this post.

This environment along with what the Federal Reserve does…or doesn’t do…is crucial to the possible “macro” position a person could in their investments and in their business decisions.

For example, John Paulson, the hedge fund investor, has apparently started placing his bets with respect to current economic and financial conditions and with respect to what the Fed can…or can’t do.  Mr. Paulson, according to recent regulatory fillings, has been re-arranging his portfolio…increasing his position in gold and reducing other positions…in anticipation of higher future levels of inflation.

Future inflation is certainly a concern and I will discuss this a little later, but there are also other issues that need to be discussed as well.

For example, dominating discussions about the current environment is the rate at which the economy is growing.  In the second quarter of 2012, real GDP grew at a 2.2 percent year-over-year rate.  I am expecting this growth rate to remain around 2 percent for the next year or so.  This expectation is backed up by other numbers, like that for industrial production.  Economic growth has been tepid, is tepid right now, and is expected to remain tepid for the near term. 

There are numerous reasons why economic growth is likely to remain slow.  I have reported on these in many recent posts.  A short list of reasons include continued deleveraging of the private sector; under-employment of eligible labor; residential mortgages being underwater; bankruptcies and foreclosures; commercial real estate losses; health of a large portion of the banking system; the financial condition of state and municipal governments; the uncertainty that exists with respect to government policy and regulation; the European recession and sovereign debt crisis; and the slowdown in other countries like China, Brazil, and India.

I believe the American economy will continue to grow but only at or below a 2 percent year-over-year rate.  This is an environment of stagnation with unemployment and under-employment staying high and capacity utilization of industry remaining historically low. 

Given this basic scenario, interest rates will rise over the next year or so.  There are, I believe, three reasons for this. 

First, interest rates in the United States are as low as they are because of the “haven” nature of US government debt.  Large quantities of “risk averse” funds have flown into American security markets escaping the mess in Europe.  As a consequence, the yield on 10-year US Treasury securities closed at 1.82 percent on August 17.

If one subtracts an “expected rate” of inflation from this figure, let’s use 2.00 percent (which is about what the inflation rate is in the United States using the year-over-year rate of increase in the GDP implicit price deflator).  Then an estimate for the “real” rate of interest is a negative 18 basis points.  This is not too far off the yield on the 10-year TIPS bond, which was a negative 45 basis points on August 17.

And, what “should” this real rate of interest be?  I have always argued that “the” real rate of interest should be somewhere around the level of the “expected” real rate of growth of the economy.  Thus, from the 1960s through the end of the century a 3.0 percent rate worked out to be a good working estimate of the real rate.  If we use my current “expected” rate of growth of the economy, 2.0 percent, then the “real” rate of interest in the United States should be in the 1.50 percent to 2.00 percent range. 

Therefore, as the “risk averse” money leaves United States shores, the yield on TIPS should rise fairly steeply.  Whether or not this rise will be resisted by the Federal Reserve is a question that remains unanswered at this time.  Resisting the rise will just cause to Fed to flood the banking system with more excess reserves, which may cause other problems.  But, this is something that the monetary authorities are going to have to face.

The second reason for a rise in interest rates is that there should be, sooner or later, demand pressure on interest rates due to a pick up in economic activity…or,  Right now, commercial banks are awash with funds while at the same time loan demand seems to be particularly weak.  Thus, there is little or no pressure for interest rates to rise.  This is certainly something we need to watch out for. 

However, we could see interest rates rise for a third reason…a rise in the expectation of future inflation.  This is something many people…like John Paulson…are worried about.  Never before has the commercial banking system had so many excess reserves “hanging around.”  In August 2008, before things fell apart, the excess reserves of the whole banking system amounted to less than $2.0 billion.  In the two banking weeks ending August 8, 2012, excess reserves in the banking system averaged $1.5 trillion. 

The monetary base, the foundation of credit expansion in the United States, was around $2.7 trillion in the banking weeks ending August 8: it was at $842 billion in August 2008!

Few people believe that the Fed can withdraw a major part of these funds from the banking system once banks start lending again…and inflation starts to increase.  Inflation and credit expansion go hand-in-hand.   And, the lending could pick up even if real economic growth does not pick up.

A further question exists: how can the Federal Reserve withdraw funds while the federal government is still running annual budget deficits of $1.0 trillion or more?

So the third reason for interest rates to rise is that as inflation accelerates in the United States, the expectation of future inflation will also rise.  When this will begin and how fast will it take place is, of course, the big question.

There are other possible “macro” effects surrounding this picture.  For example, what will happen to the value of the dollar given this view of the world?  These will be addressed in future posts.

Does one get a sense of potential “stagflation” in what is written above?  Slow economic growth, rising inflation, and rising interest rates.  How does a central bank combat such a situation?

The situation that Mr. Bernanke and the Fed face is a very challenging one.  It is a situation that they have helped to create.  But, getting out of it will not be much fun for them.

As far as the private investor is concerned…a situation like this presents a ton of possible “investment” opportunities.  And, one should always ask, “How can I make money from a situation like the ones described above?” 

As one reads a book like “More Money than God” by Sebastian Mallaby, one observes that lots and lots of money is made off of government mistakes.  The problem is that generally the people that make the money off of these mistakes are people that have the information, the access, and the scale to take advantage of the mistakes.  However, these “tools” are not available to most people.  Maybe that is why the distribution of wealth in the United States has become so skewed.    

Thursday, August 16, 2012

Municipal Governments: Default Rates Higher Than Thought

“Moody’s Investment Service has reported that from 1970 to 2011, there were only 71 municipal bond defaults.  But (a Federal Reserve Bank of New York) report counted 2,521 defaults.”

“The report found a similarly vast gap in the raw numbers of defaults when it looked at data from Standard & Poor’s.  The Fed’s combined database indicated 2,366 defaults from 1986 to 2011, compared with S & P’s 47 defaults during this same period.”

These quotes are taken from the New York Times article, "Muni Bonds Not as Safe As Thought".

The difference in the figures is that Moody’s and Standard & Poor’s just report on rated bonds whereas the report of the Federal Reserve Bank of New York considers both rated and nonrated bonds.

Now most investors and investment funds just invest in rated bonds so that the report of the rating agencies represents what most of these investors face.  And, the default rate of the rated municipal bonds rests slightly below one percent.

However, if we are looking at the state of the economy and the state of municipal finances we need to look at all defaults and not just the defaults of the rated issues. 

But, we need to look deeper into the whole municipal financial to really understand what it going on in the municipal area.  “The Fed researchers said that debt backed by a city’s own general obligation pledge seldom defaults, while debts backed by revenues generated by individual projects were more uncertain.”

Bonds related to housing projects contributed 17 percent of the defaults; nursing homes accounted for 12 percent; and health care projects provided 11 percent.  But, the largest contributor was industrial development bonds, which made up 28 percent of the defaults.

And, it seems that municipalities are taking more and more risks on bonds, some of them related to educational efforts.  See the reference to the issue by the San Diego educational authorities mentioned in my August 11 blogpost, "Sour Time for Cities".  In this case, Poway Unified, one San Diego educational district, issued 7 percent “capital appreciation” bonds.  There is no need for Poway Unified to pay back interest or capital until 2033, and when the bond is repaid in 2051, the district will have paid back to investors 10 times the amount initially borrowed.

The total default rate on municipal bonds, both rated and non-rated appears to be about 4.5 percent.  This in not a huge number, but it is certainly not as low as most of us perceived the default rate on municipal bonds to be. 

Also, the Fed researchers noted that municipal defaults are not as closely tied to economic downturns, as are corporate issues.

The trend in municipal defaults seem to be tied to longer, more secular movements in the economy and not just business activity.

For example, at the start of the period covered by the research, 1970, public labor union membership was a very small of the labor union movement and not particularly strong.  Currently, public labor unions make up over 50 percent of the membership of labor unions in the United States.

Furthermore, in 1970, homes in the United States had not become the “piggy bank” of the middle class.  The inflation of home prices really began in the late 1960s and early 1970s and the almost continuous rise in the price of housing became the “go to” source of revenue for governments to raise the salaries, pensions, and other benefits of rapidly growing municipal employment roles.

According to the Federal Reserve figures, only 155 municipal defaults took place between 1970 and 1986…sixteen years.  This meant that about 10 defaults took place every year during this time period. 

From 1986 through 2011, 2,366 defaults took place.  Over this latter 25 years, the country averaged almost 95 defaults per year. 

And, the number of defaults was much greater during the latter part of the period than it was in the late 1980s and early 1990s.

Bottom line: municipal bond defaults are much more of a problem than many people have believed to be the case.  And, from all indications we are not out of the woods yet in terms of turning this situation around!

I have written a lot over the past year or so about the problems facing state and local governments.  Unfortunately, many state and local governments are not unlike the Greek government in under-reporting their fiscal situations.  And, in many cases we are just learning about them now.

I believe that we are still facing many problems in the state and local government realm due to unreliable accounting practices, declining tax base, promises to constituents relating to social services and education, and militant public labor unions.  Working out these problems is not going to be pretty…but, state and local governments cannot return to a prudent operating condition until they are worked out.

As a consequence, there will be many more bond defaults in the future, especially municipal bond defaults.  They may be non-rated bonds, but they are municipal bonds, but they are municipal bonds none-the-less.  These defaults will continue until these institutions get their act together and their budgets and accounting by in line. 

Wednesday, August 15, 2012

The US Economy: Modest Growth Continues

The July numbers for industrial production have just been released and all one can say about them is that the economy is just showing “more of the same.”  The year-over-year rate of increase of industrial production for July was 4.4 percent.  The average rate of increase for the first six months of 2012 was 4.8 percent.   

Economic growth, as captured by the rate of increase in industrial production, has not been strong and economic growth remains weak.  This growth is not inconsistent with the rate of growth of real GDP, which has been around 2 percent, year-over-year, through the second quarter of 2012.

This rate of growth is not sufficient to reduce the amount of unemployment in the United States and is specifically not sufficient to reduce the amount of underemployment in the nation, which remains in the 15 percent to 20 percent range. 

It is also not sufficient to raise the rate at which manufacturing capacity is used in the United States.  Although the rate of capacity utilization has moved up modestly in recent months, it still remains below the level it was at just before the recent recession set in.

There is much unused economic capacity in the United States these days and the economy is not growing sufficiently to cause this unused capacity to shrink much at this time.  For one, there are just too many problems that people have to deal with before full blown economic growth can continue again.  

Some of these problems have to do with the amount of debt still outstanding in the United States; one out of four residential mortgages are still “underwater”; the are substantial problems in the area of commercial real estate; state and local governments still have massive problems in the area of pensions and debt outstanding (see my recent post titled "Sour Times for Cities"); and there remain many problems in the banking sector…among other things.

Many of these problems need to be “worked out” before people, businesses, and governments can start spending again.   And, this spending must be stepped up if the economy is to return to a level of economic growth more consistent with the last half of the twentieth century.

In addition, people and businesses still need some indication of where government policy is going to go.  This is perhaps the ultimate need.  Right now there is little or no indication of what future government economic policy is going to be.  People and businesses find it very difficult to commit in such an environment.  I am afraid that we are just not going to get much pick up in the commitment people and businesses until they get some idea about what kind of environment the government is going to create for the future.  Right now all they can focus in on is more deficits of one trillion dollars or more and more and more debt.  And, this provides little or no help to them in making decisions about how to spend their funds. 

So, economic growth is going nowhere.  As a consequence, a substantial amount of economic resources are going to remain unused. 

This scenario is not going to change before the presidential election in November.  It is highly unlikely that it will change much over the next year or so. And, this will be the environment we all are going to face in making spending and investment decisions during this time.