Friday, October 24, 2008

Credit Markets

I have heard commentators (Larry Kudlow) making the argument that the credit markets are working OK because bank loans are up by some pretty high numbers. That got me wondering, so I looked at the percentage change in total bank credit plus asset-backed commercial paper from end of September to end of September the following year. The data include Loans and Leases in Bank Credit based on Statistical Release H.8 from the Federal Reserve (the "Fed") and asset-backed commercial paper outstanding from the Fed's Data Download Program. (In 2006 I had to use the October ABCP outstanding due to a gap in the data.) The first graph shows the results.

(Loans and Leases in Bank Credit plus ABCP)

As illustrated by the graph, total credit growth is actually quite meager. The true situation is, however, much worse. I illustrated this by taking out of total credit in 2008 outstanding loans made by the Fed and securities lent to dealers*. In other words, I am trying to isolate the private banking system itself as if the Fed's loans were to be repaid (of course, they cannot be). The second graph shows the result.

(Less Fed credit)

Credit coming from the private system is down - a lot - not up. Without the Fed's interventions we could be bartering by now. Now, there are a lot of other pieces to the puzzle, but this is certainly a more troubling view of the credit markets. Granted Mr. Kudlow was referring to the most recent 13 weeks, but if you calculate credit the way I have I still do not see any increases in credit coming from the private banking system.

* This includes the net Repo position of the Fed, the TAF, the PDCF, the Bear Stearns loan, loans to AIG, the TSLF, and the new asset-backed commercial paper financing. It does not include the new facilities announced by the Fed that are scheduled to begin Monday for the purchase of commercial paper and, as of the other day, other assets by the Fed.

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Monday, October 13, 2008

Credit Problems Beyond Subprime

When the subprime credit crisis began to unfold in 2007 I believed it was a sign of deeper problems in the credit markets. Easy money and unchecked leverage puts pressure on banks to lend. First they make the good loans, then the not so good ones, and then they make bad loans. So far most of the media attention has been on the subprime mortgage crisis. Last week, to little fanfare, the Shared National Credits Program released the results of its review of loans to corporate borrowers that are shared by banks in the US, banks overseas, and other institutions such as pension funds, hedge funds, and insurance companies. The review is of:

loan commitments of $20 million or more and held by three or more federally supervised institutions
The review shows considerable deterioration in credit quality of these loans.
Criticized credits increased $259.3 billion and represent 13.4 percent of the SNC portfolio compared with 5.0 percent in the 2007 SNC review. Credits rated special mention (potentially weak credits) increased by $167.9 billion and represent 7.5 percent of the SNC portfolio compared with 1.9 percent in the 2007 SNC review. Classified credits (credits with well-defined weaknesses) increased $91.5 billion and represent 5.8 percent of the SNC portfolio compared with 3.1 percent in the 2007 SNC review.
Even more interesting is how the criticized loans are distributed:
Classified credits held by non-bank entities increased to $70.0 billion from $34.8 billion and represent 42.9 percent of classified credits. The volume of classified credits held by non-banks is particularly significant given their relatively small 19.9 percent share of the SNC portfolio.
The distribution could be due, in part, to purchases by non-bank entities of credits at a discount from face value but the report is silent on this point.

So what does all of this show us? It demonstrates the fact that subprime was one area of the credit binge of the past few years. Subprime is certainly a very big part of the credit crisis, but it is not the only part. Here is what the review states about underwriting standards for these $2.79 trillion of loan commitments with $1.2 trillion outstanding:
For the second consecutive year, the review included an assessment of underwriting standards. Examiners again found an inordinate volume of syndicated loans with structurally weak underwriting characteristics particularly in non-investment grade or leveraged transactions.
Add to this portfolio and mortgages all of the other loan portfolios, including credit cards, auto loans, corporate loans, small business loans, and so on, and this crisis goes well beyond subprime mortgages. Just how far is impossible to tell, but the rapid deterioration in the portfolios of major banks, such as the loss reserves announced by Bank of America, give us an indication. As reported in The Wall Street Journal Online Edition:
The nation's largest retail bank reported net income of $1.18 billion, or 15 cents per share, down from $3.70 billion, or 82 cents per share a year earlier. The results were worse than expected. Credit losses on mortgages and credit cards dragged down the results. Its provision for credit losses was $6.45 billion, up from $5.83 billion in the second quarter. Net charge offs were $4.36 billion, as compared to $3.62 billion in the second quarter.

Nonperforming assets were $13.3 billion, or 1.42 percent of total loans, leases and foreclosed properties. The dividend cut at Bank of America, the country's largest bank in terms of deposits, mirrors similar moves by smaller banks across the country as they look for ways to cut costs and raise capital amid the volatility that has driven some of the country's biggest financial institutions out of business.
For more on credit cards see this WSJ article.

I think the credit crisis and its impact on the economy have a long way to go. There are many reasons I believe this and I have been writing about them for the past year. What I found amazing and would like to point out is just how rapidly Wall Street greed exploded, bringing the financial system to its knees. In 2004, investment banks and commercial banks were recipients of deregulation relating to the amount of leverage, on and off their balance sheets, they could employ. There have been many reports on these events, including this New York Times article addressing the investment banking regulations, this blog piece by yours truly addressing both sets of regulations, and this one I penned last May pointing my finger at Bush appointed regulators. Two years after these regulatory changes, the system imploded. True, there are many other issues that are much longer term in nature. In particular, unregulated derivatives markets turn out, not unexpectedly nor without warning, to be a major structural problem in the financial system, and easy monetary policy plus global liquidity were certainly contributing factors. But notwithstanding these other factors that come in to play in this crisis, the simple fact is that if regulators had limited the amount of leverage financial institutions could employ we would not have necessarily reached the crisis stage.

In 2004 regulators gave Wall Street some rope, and it took a mere blink of the eye for Wall Street to hang itself (and, unfortunately, a lot of others).

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Friday, October 10, 2008


Today was one of the most interesting days I have ever witnessed in the markets. I am not a market expert so take all of this with a grain of salt, but it was watching history in the making.

I would say it was a really bad day like last Friday. Last Friday I wrote that it was a really bad day that did not bode well for the markets. This week certainly seemed to support that logic with the DOW having its worst week ever in its 112-year history. It was a really bad day last Friday because the credit markets were screaming with the TED Spread at historic highs and prices of everything down on the day (everything except Treasuries). Stocks, oil, and even gold fell last Friday. By that logic today was even worse.

Today the TED spread was even higher than last Friday, stocks, oil, and gold all fell again, and unlike last Friday even Treasury securities fell in price. It feels as though there is a mass liquidation going on as investors scurry to meet margin calls. Sell anything and everything – we need cash! De-leveraging is in high gear this week.

There were, however, some encouraging signs in the stock market today. After falling precipitously at the open, over 690 points down, the DOW recovered and went positive for a while in what was a stunning reversal. It then lost steam and spent the better part of the day down between approximately 250 – 500 points. At the end of the day the index made another comeback, again turning positive by over 300 points before ending down a “mere” 128 points (seems like small potatoes now). The spread between the high and low of the day, 1,018.77 points, was the largest ever in the history of the DOW. The Nasdaq ended up just ever so slightly.

Summing it up, virtually all asset classes were down today including stocks (on NYSE record volume), bonds (including Treasuries), and commodities (including gold), while the credit markets remained in shambles. This suggests the markets are in full de-leveraging mode and its sell first, ask questions later. There were, however, two remarkable intra-day rallies in the DOW and the Nasdaq ended up for the first time all week, providing a glimmer of hope. It really did seem as though bargain hunters came out in force today and scooped up stocks on the cheap when the market was under extreme pressure. Whether this is a sign that things will moderate is impossible to tell and in the end all asset classes ended down in price. It was comforting, however, to see the cash coming to the table. Even I dipped my toe in the water and I am extremely bearish. Greed got the better of me but I kept it in check by making only small purchases and putting on a hedge. Unfortunately, if nothing changes for the better over the weekend and the de-leveraging continues, next week could be another painful one. There were hopes that the G-7 Finance Ministers and Central Bank Governors would come out with a coordinated plan of action to battle the credit crisis and that may have been fueling some optimism. Unfortunately there was no plan, only a "commitment" to continue working together to stabilize the credit markets – something that has not happened yet. One thing that has happened – I have a splitting headache from following this week's gyrations. TGIF!

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Tuesday, October 7, 2008

More From The Federal Reserve

The Federal Reserve announced today that it will form a special purpose vehicle (the Commercial Paper Funding Facility or CPFF) that will purchase commercial paper in the marketplace from qualified issuers. This raises many questions, such as whether the Fed is now rationing credit to US companies without oversight.

The Federal Reserve is already in effect purchasing asset-backed commercial paper through its Asset-Backed Commercial Paper Money Market Liquidity Facility (ABCPMMLF) where it is lending money to banks to purchase commercial paper that is then pledged to the Federal Reserve. The twist here is that the loans to the banks are non-recourse, so if the commercial paper defaults the Federal Reserve is stuck, not the bank that borrowed the funds – same risk as ownership if you ask me. This action was authorized pursuant to section 13(3) of the Federal Reserve Act (see below). The commercial paper that banks are purchasing and pledging to the Federal Reserve under the ABCPMMLF is secured by the assets backing the asset-backed commercial paper.

The Federal Reserve is now expanding its use of this authority to purchase commercial paper directly from issuers that may be non-bank companies raising the prospect that the Federal Reserve will be rationing credit to US businesses. There is also an issue of authorization, and it seems definitions are malleable in times of crisis. From today’s announcement:

The CPFF will be structured as a credit facility to a special purpose vehicle (SPV) authorized under section 13(3) of the Federal Reserve Act. The SPV will serve as a funding backstop to facilitate the issuance of term commercial paper by eligible issuers.
According to section 13(3) of the Federal Reserve Act:
3. Discounts for Individuals, Partnerships, and Corporations In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank (emphasis added): Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.
According to the highlighted section of the Act the commercial paper purchased by the Fed must be SECURED. My understanding of security in lending transactions is that there is a guaranty or some form of asset available to the lender that can be sold in the event of a default, the proceeds of which would be likely to repay the debt. According to the Federal Reserve's release:
Commercial paper that is not ABCP must be secured to the satisfaction of the Federal Reserve. The commercial paper may be secured in one of the following ways: (i) The issuer pays the SPV an upfront fee based on the commercial paper initially sold to the SPV and a further fee based on subsequent commercial paper sales above that amount (emphasis added); or (ii) The issuer obtains an indorsement or guarantee of the issuer’s obligations on the commercial paper sold to the SPV that is satisfactory to the Federal Reserve; or (iii) The issuer provides collateral arrangements that are satisfactory to the Federal Reserve; or (iv) The issuer otherwise provides security satisfactory to the Federal Reserve. The Federal Reserve will consult with market participants about other methods for issuers of non-ABCP commercial paper to provide satisfactory security to the Federal Reserve.
I wonder how being paid a fee for purchasing commercial paper meets the definition of SECURED under the Federal Reserve Act quoted above. It sounds more like creation of an insurance pool to me. Shouldn't the Federal Reserve obtain Congressional approval to purchase commercial paper from issuers in this manner? The authority is not clear to me.

I do not object to the Federal Reserve taking whatever action is within its authority that could help avert a financial disaster. What I do object to is when institutions bend the meaning of laws to accomplish what they want but then speak about the rule of law and the need to police the actions of those who seek to avoid compliance. Isn't this exactly how we got into this mess in the first place? I am also troubled by the fact that the Federal Reserve can now be seen as rationing credit to US corporations and that this situation is ripe for abuse through influence. There should, in my opinion, be oversight.

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Monday, October 6, 2008

Fed Goes Nuclear

The Federal Reserve is going nuclear. The TAF is doubling to $900 billion, interest will be paid on reserves beginning October 9, and the rules prohibiting commercial banks from purchasing assets from affiliated money market mutual funds is being relaxed. This last move puts FDIC insured deposits behind money market mutual funds which is, I believe, a roundabout way to get taxpayers behind the funds. They previously did this for the investment banking affiliates. The interest on reserves is required because the Fed is flooding the system with reserves and if it did not pay interest on reserves its target rate would be meaningless, as overnight lending rates would plummet to near zero. This is amazing – unfortunately - and there is likely more to come. Who thought $700 billion was a lot?

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Thursday, October 2, 2008

Why It’s a Bad Day

Today was a bad day.

First, the credit markets are screaming. The TED Spread is at historic highs. If you don’t know what the TED Spread is, it measures the difference between the interest rate paid on Treasury securities and the LIBOR rate. LIBOR is the London Interbank Offer Rate, and that is the rate banks offer to lend dollar reserves to one another in London. So why is the difference between these two rates important?

Rates on Treasuries are staying way down because investors don’t know where to put their money to keep it safe, let along make a return. So they run to the safest investment they can find – Treasuries. This is called a flight to quality. On the other side, banks don’t want to lend to each other. This is in part because they are afraid they will not get paid back and in part because they are concerned their funding sources may dry up so they are hording reserves. This is a sign that the banks are very nervous. The bigger the difference between these two rates, the more fear in the markets.

The other very troubling sign is the concurrent declines in oil, stocks, gold, and other metals on the heels of an already declining housing market. Usually, when the stock market is down, you can watch the funds flowing into gold or oil or some other investments. Now, however, that’s not happening. Stocks are being sold off and the money is going out of the markets, perhaps into Treasuries and perhaps under the mattress. This could be a sign that large investors such as hedge funds are selling to raise cash for distribution to withdrawing investors or meeting margin calls. It could also be a sign that investors appear to be coming to terms with a very poor global economic outlook. In any event what we are seeing is signs of deflation. If you have any doubts about why deflation is bad, think about paying off your mortgage as the value of your house, your wages, and everything else falls except the amount you owe. Think about a business investment when the value of the product you will produce is likely to decline while the loan you use to finance the investment does not. Deflation is a really bad thing because it hurts the wealth of anyone who is a net borrower (most households) and it discourages investment leading to more unemployment. More unemployment on top of an already weak labor market can result in a downward spiral as consumption shrinks due to job losses causing more job losses causing less consumption, etc.

Warren Buffet has been in the news lately. Many have felt comforted by his investments in Goldman and GE. I have not, because it tells us that the bluest of blue chip companies are now paying 10% plus equity warrants at or around current market prices to raise capital. This is to replace short term funding from sources such as commercial paper where rates are (or were) much lower. This tells us financing is very difficult to obtain and the higher cost of funds will likely have a negative impact on future earnings.

In the long run, it shows that Buffet has faith in the United States and that's good. What happens between now and the long term is what has me concerned. One day does not a trend make, but this is not a good day.

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