Understanding the Inflation Report

The Bureau of Labor Statistics (BLS) reported today that inflation was contained in April, with prices rising only .2% (this would be about 2.4% on an annualized basis). This was welcome news for the equity markets that responded positively to the report. Sounds good, except we have the usual adjustments and assumptions built into how this number is calculated. The biggest standout in this report is Transportation, which is down by .7 percent in April. Lets take a look at this category to try and understand how these numbers work.

Here is the report’s discussion of why Transportation prices fell by .7% in April:

The transportation index declined 0.7 percent in April, reflecting a 2.0 percent decrease in the index for gasoline. The index for new vehicles declined 0.2 percent and was 1.3 percent lower than in April 2007. The index for used cars and trucks declined 0.3 percent in April, but was 1.8 percent higher than a year ago. The index for public transportation declined 0.4 percent in April, reflecting a 0.5 percent decrease in the index for airline fares. (Prior to seasonal adjustment, airline fares rose 0.9 percent and were 10.1 percent higher than a year ago.) (Gasoline prices rose 5.6 percent in April. Compared to a year ago, these prices were up 20.9 percent. Gasoline prices increase seasonally during the first five months of the year, with the largest increases occurring in March and April and decline seasonally for the remainder of the year).

Taking a closer look at this part of the report, it states that the gasoline price index is down 2 percent in April. This would probably surprise most drivers. In fact, gasoline prices were up 5.6 percent in the month, so how can they be down 2 percent? Well, the government expects gasoline prices to go up 7 percent in April as people drive more, and then go down later in the year as people drive less. Because prices only rose 5 percent, the seasonally adjusted price index fell 2 percent. This assumes that gas prices will, as the report states, decline seasonally from June through December. We know, however, that oil prices have risen for future delivery and gasoline prices are expected to go up, not down. Based on the seasonal adjustment figures, prices should go up about 3.5 percent in May, then drop for the rest of the year. So should the gasoline number be seasonally adjusted downward by 5.7 % even though oil futures are up? I suppose what that means is that future inflation numbers will be worse.

The next subcategory is new vehicles. According to the report new car prices fell .2 percent (the seasonal adjustment for this category is .22 percent, so prices must have fallen by approximately .4 percent). This is interesting, especially when Toyota just announced price increases for their new vehicles in the U.S. These increases will reportedly become effective later in May, so this price decline will likely also reverse next month or in June. That’s bad news because based on the seasonal adjustments, car prices are supposed to go down .32 percent in May and .33 percent in June, so once adjusted this category could look even worse.

The drop in the price of used cars and trucks is not surprising given that we are in the midst of a shift to more fuel efficient vehicles. Used vehicles, which would tend to be high fuel consumption vehicles, are declining in value. If a person goes to buy a new car, don’t they usually trade in the old one? So if the value of the old one declined, the actual cost of a new car, on a net basis, has not declined by .2 percent because the buyer will get less credit for the trade-in. So this is good news for used car buyers but not as good for people who buy new cars.

Finally, airline fares declined! That’s news to me. Before seasonal adjustments they were up .9 percent. So if the reported number fell .4 percent, we know the expected seasonal rise must have been 1.3 percent (there are rounding issues – the actual adjustment is 1.44 percent). Because they rose only .9 percent, on a seasonally adjusted basis they were down .4 percent! What about the fact that the Easter holiday was in March this year but April last year? The seasonal adjustment is down a bit from last year, from 1.95 percent to 1.44 percent, but so is the March adjustment, from 1.23 percent to 0.97 percent. These changes do not reflect adjustment for this point as far as I can tell. Airline prices may reflect this increasing a seasonally adjusted 3% in March and decreasing a seasonally adjusted .4 percent in April.

Seasonal adjustments do make sense to me on a normal ongoing basis, but when we have better information (such as futures prices for oil) perhaps we should take that information into account. Then again, there is a lot to be said for consistency, so making adjustments to adjustments may not be such a great idea. Finding the real story, however, requires work.

In the unlikely event that you would like to look at other categories in this way you can find a lot of information at the BLS. The way to do it is look at the seasonal adjustment table for 2008. The expected change is the percentage change in any given category from one month to the next. If you get a 1 percent increase, then an actual increase of 1% will be reported as a zero percent increase. If you are a statistician and want to get into the calculation of the seasonal adjustments you can start with this report.

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Subprime and the Bush Administration

What did the Bush Administration have to do with the credit crisis? I keep hearing people say that a president does not have very much influence on the economy and they are given too much of the credit or blame when the economy fluctuates. I disagree for two reasons. The first is that fiscal policies can have a rather dramatic and immediate impact on economic activity as the President is making clear today by touting the fiscal stimulus plan. Tax cuts and government spending certainly impact the economy in a direct and timely way. The other reason is the general regulatory oversight that each administration is responsible for. For example, who heads the SEC and what are the priorities given it by the administration? What about the Treasury Department? I believe these policies have a direct impact on economic activity and are responsible for a lot of the fluctuation in the economy as well as income distribution from one administration to another. Here is an example.

As hedge fund investor David Einhorn laid out in his recent remarks, ”Private Profits and Socialized Risk” the SEC, under the Bush Administration, altered the capital requirements for broker-dealers. Einhorn concludes that the result was a lower capital requirement leading to higher leverage. The higher leverage, as we know, leads to higher risk and that higher risk culminated with the failure of Bear Stearns. So, is this why we have the credit crisis? Wait, there’s more.

The SEC regulations applied to the broker-dealer world. What about the commercial banks? What have they got to do with all of this? Well, as I wrote about last October, the rules regarding commercial bank capital requirements were also altered back in 2004 through rules promulgated by the Federal Reserve and Treasury as regulators of the commercial banking system. In effect, these rules said to banks they could move loans and other assets from their balance sheets to off-balance sheet conduits and reduce their capital requirements. Banks love this because it allows them to – guess what – leverage! They set up something called a conduit that purchases assets from the bank and/or a bank customer. The conduit gets the money for the purchase by issuing securities, like commercial paper. The rating agencies rate the commercial paper based, in part, on the fact that the bank typically provides a line of credit to the conduit so that if the commercial paper market dries up the conduit can borrow to repay maturing commercial paper. This is a very general description and these structures can get very complex, but this is the basic idea. So how does this increase leverage? The rules promulgated in 2004 established that under this structure banks could provide these credit lines to back these conduits but hold only 10% of the risk based capital they would hold against the same assets if they were on the bank’s balance sheet. You can find the announcement of the rules here. So, using this structure, banks can leverage their capital in multiples. Eureka – a way to get around the sound banking principals established by the regulatory framework over the past 90 years! The regulators behind these rules included the Office of the Comptroller of the Currency (Treasury), The Federal Reserve System, The Office of Thrift Supervision (Treasury), and The Federal Deposit Insurance Corporation.

Lets review. According to Mr. Einhorn, in 2004 the SEC relaxed capital rules for broker dealers, placing more of the regulatory requirements in the hands of the banks and allowing them to use more leverage than before. In the very same year the Federal Reserve and Treasury codified the rules that permitted commercial banks to leverage through off-balance sheet entities. (In case you were wondering, Congress had hearings on many of these issues as well.) All of this turned out to be extremely profitable for the banks, brokers, and rating agencies.

Suddenly, there is an incredible credit bubble that begins with loans and ends up as securities in the portfolios of, among others, the investment banks, banks, and off-balance sheet bank sponsored conduits. I wonder if there is a link between these events? Now, to be fair, the credit bubble began a little before these regulatory changes. But these changes must have accommodated a huge demand that was unsustainable. The graph accompanying this post illustrates the credit bubble I am referring to.

What really caps all of this off is the cries from many of these agency heads now about what should be done to fix this mess. For example, Sheila Bair, head of The Federal Deposit Insurance Corporation, has been calling for months for a bailout of subprime borrowers. First, back in October, she called for a freeze on interest rates for those who had adjustable rate subprime mortgages. She is now lobbying for loan modifications to reduce principal for those subprime borrowers whose mortgages exceed their property values. From her recent comments before Congress

Permanently forgiving part of the principal amount can provide a better financial result for investors than foreclosure by creating long-term, sustainable solutions that will allow borrowers to stay in their homes. This approach also has the added benefit of limiting the overall adverse affect of declining property values on communities.

In closing, Ms. Bair states

Congress, the SEC, the Treasury Department, as well as federal bank regulators have expended considerable time and effort to assure that the industry has authority under tax and accounting rules to modify loans proactively. The industry needs to demonstrate greater commitment to using those authorities.

They should be expending all the time they possibly can and they should never mention it because these agencies are collectively, in my opinion, among the most culpable groups in this entire debacle.

To be fair to Ms. Bair, she was appointed to head the FDIC in 2006, after these regulatory changes. She was, however, on the FDIC’s Advisory Committee on Banking Policy. Donald Powell was FDIC Chairman in 2004, John Snow was Secretary of the Treasury, William Donaldson was Chairman of the SEC, and our old friend Alan Greenspan was Chairman of the Board of Governors of the Federal Reserve System. Who appointed these people?

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Some Hidden Costs of the Credit Crisis

The Federal Reserve (the Fed) is likely causing dramatic distortions in the markets by lowering interest rates below the level of inflation and the impact may only be evident in retrospect. One side effect of the Fed's actions is a massive shift of the costs associated with the credit crisis from borrowers to savers. While negative real interest rates are helping some homeowners keep their payments down they are also fueling inflation resulting in a tremendous loss in value to those who have saved for retirement. Artificially low interest rates are also causing pain for those living on a fixed income through both inflation and loss of investment earnings. Here are a couple of hypothetical situations based on real stories I am hearing from friends and relatives to illustrate these distortions I am referring to.

The first story is about a hard working middle-class family headed by Dick and Jane. Dick and Jane grew up in the 1950s and 1960s. They have worked full time for almost 40 years, raised a family, a dog and several cats, and have been preparing to retire. They have contributed to Social Security from every paycheck they have ever received, and have been frugal and lucky enough to put aside some money for retirement. They purchased their home 30 years ago and have paid off the mortgage through 360 consecutive monthly payments of principal plus interest. Everything was going along according to plan until, suddenly and without warning, the earnings on their investments began to plummet.

They couldn’t understand what was happening at first. Because they were getting close to retirement they had allocated much of their portfolio to fixed income investments, and some of those were falling in value at the same time they could not get more than a 3% return on CDs and Treasury securities. They went to their bank to get advise and were told that because the Federal Reserve had lowered interest rates safe investments were yielding very low returns. They took out their calculator and figured that if inflation is around 4% and the real interest rate is 2.5%, they should be earning 6.5% on a risk free investment. Instead they are being offered 2.5% on a CD, so the cost to them is 4%. Based on their retirement portfolio of $750,000 they are losing $30,000 per year! Even if they can get a 3.5% return the cost is still $22,500 per year. But that’s not all. If we believe that these low interest rates are also causing inflation in basic goods such as energy and food, the value of their retirement savings is declining. Where $750,000 may have been enough based on all reasonable forecasts just a year or so ago, now it is not enough because of the cost of living increases.

Confused and angry, Dick and Jane reconcile to the fact that they will likely not be retiring as planned unless they cut back dramatically and save as much as possible. They will delay any major expenditure until absolutely necessary, and because of inflation they have less to save. The $1,100 fuel oil bill drove this point home last week. A portion of their retirement has disappeared through no fault of theirs, and they wonder why. Why is it that with inflation getting worse interest rates are going down? Shouldn’t it be the other way around?

The second story is about Cathleen, a neighbor of Dick and Jane. She retired from her clerical position ten years ago. Her husband passed away several years back and she now lives on Social Security and the income from the $250,000 portfolio of treasury securities, money market accounts, and CDs left from their lifetime savings and her husband’s live insurance. She can’t understand what is happening, but for the first time since retirement she must liquidate some of her retirement portfolio to pay all of her bills. Her Social Security income of $1,500 per month doesn’t come close to covering all of her expenses so she has relied on the interest from her portfolio for the rest. Last year her interest income was $13,750, giving her total income with social security of $31,750. This year her interest income was $8,750 giving her total income of only $26,750. Adding the rising costs of her medications, property taxes, food and energy she is for the first time concerned that she could run out of money. She wonders why, and she has decided she must cut back to only the necessary expenditures.

While lower interest rates are helping some homeowners with adjustable rate mortgages they are hurting savers and those living on a fixed income. Inflation also harms savers but benefits borrowers. At the same time, as between the average savers and the average adjustable rate mortgage borrowers it is the latter who have more culpability for the crisis in the first place. It is clear that the American people are paying the price of this credit crisis one way or another, and the question at hand is whether the distortions resulting from the remedy are making things better or worse as the burden is shifted from borrowers to savers?

There are at least three reasons for the Fed to be lowering rates right now. Let’s take a look at each of the primary reasons for the Fed to be lowering interest rates.

The first reason to lower interest rates when the economy is soft is referred to as the wealth effect. When interest rates are lower asset values tend to be higher. If mortgage payments are lower house prices can be higher because it is more affordable based on the payments. This applies to financial assets as well. As interest rates fall, in general, the value of financial assets rise. In practice, this effect makes people feel better off because their assets are worth more and this is good for the economy because when people feel wealthier they tend to spend more. This sounds great, but there is dark side.

When inflation becomes a problem rising asset values tend to be offset by rising costs. While keeping interest rates depressed may help support the value of certain assets it is also fueling inflation, and the inflation is countering the wealth effect. Low interest rates don’t always spark inflation, but in the current global economic situation commodity prices are rising dramatically and inflation is becoming a real issue. Lower interest rates in the US hurts the value of the dollar and sparks price increases in dollar denominated commodity prices. Anyone who goes to the grocery store or drives a car or heats a home knows that inflation is a rising problem today. So assuming low interest rates are in fact supporting asset prices the resulting inflation could be countering the impact because real values (adjusted for inflation) are not changing or are, perhaps, even falling. Is the wealth effect of lower interest rates working this time? I question its efficacy under current conditions when real interest rates are negative AND we have supply shocks in energy, food, and metals all at the same time.

The second intended effect of lowering interest rates is to spur business investment by making it less expensive for businesses to borrow and invest. This should also lead to increased employment as businesses hire more workers. Before businesses invest, however, they must believe that consumers will consume. Helping to keep mortgage payments down for a portion of the population will certainly help consumer sentiment, as will the resulting benefit of slower price depreciation in housing. But there is also a downside to consumers of low interest rates and the inflation we are now seeing. The retirement savings of the baby boom population are losing value to inflation, while at the same time low interest rates are cutting into the income of those living on their savings. The loss of real savings and real income (from both depressed interest rates and the impact of inflation) to the population of savers and spenders is likely to have a negative impact on consumption, especially as those close to retirement increase savings and those in retirement are forced to cut back on spending. This, in turn, could offset the positive impact of low interest rates on consumer sentiment. Consumers also have more debt as a percent of their personal income now than at any time in the past several decades and probably need time to pay it down rather than consume more. So will lower interest rates spur investment under these circumstances or simply prolong the reckoning while causing a very troubling inflationary spiral? There is certainly room to question the efficacy of further rate cuts on business investment in the current economic climate.

The third reason for lowering interest rates right now is to help rescue the financial industry in the US and prevent a collapse of the financial system. A major meltdown of the financial industry would certainly be a problem that would have a negative impact on all of us because it could result in a severe recession or even a depression. If the banking system becomes insolvent (meaning the banks do not have capital and cannot make loans) then anything people purchase on credit could suddenly experience dramatic reductions in demand, while at the same time businesses would find it very difficult to obtain funds for investment. When things get really bad you get deflation because there is simply not enough demand for anything to keep prices from falling. This may sound OK at first but in fact it is worse than inflation in many ways. Who will lend you money to buy a house if the value of the house is expected to decline next year? The same logic holds for a car or any other major purchase. Imagine your mortgage payment staying the same while your home value and wages drop – that’s deflation and it can spiral down the same way inflation can spiral up. At the same time unemployment would rise dramatically because businesses facing falling demand and lack of funds for investment would be laying off workers. This is certainly a situation to be avoided. So how does lowering interest rates help us lower the risk of this happening? Aside from the wealth effect and business investment helping the economy stay afloat, the lower interest rates help to support the value of assets on banks’ balance sheets (remember these are interest bearing financial assets). That means fewer write downs and, in turn, lower losses and more capital. The low interest rates also reflect banks’ cost of obtaining funds to lend, and when their costs go way down their profits can go up. More profit means more capital and more incentive to lend. So lowering interest rates helps the banks to preserve and add to their capital helping to lower the risk of financial system insolvency. Of course, if this is truly the reason for lowering interest rates right now one must wonder why banks continue to pay dividends to investors. If they are under-capitalized that should be the first place they go for capital preservation, not to the policies of the Fed. This is especially true when the Fed policies are creating distortions in the market and may not be helping to support the economy for reasons discussed above. If the financial system is in fact under-capitalized perhaps the Fed should be reaching back into its bag of tricks and figuring out another way to add capital to the banking system.

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Fear or Greed (today)?

This is a very non-analytical discussion of how I have been feeling about the markets. Sometimes I sit down and do research. You know, go and get actual numbers from reliable sources and analyze what they say. Other times I just think about the general news and events and work to a conclusion based on the “how it feels” method. I have had some successes and failures using both methods. This piece is about the current state of my “how it feels” method. This can change with one news story because fear and greed are very powerful impulses.

Most professionals will tell you to pick good companies and invest for the long term. That’s probably great advice, but I don’t want to see my net worth collapse with the market, even if it is temporary. So I try to keep up with what’s going on in the markets and react accordingly. I find it exciting to watch the financial news each day as the stock market gyrates between hope (greed) and fear. Up 400 on the DOW one day, down 300 the next. Listening to the traders on money shows is interesting as they banter about their proposals for moneymaking trades. Take this position today, then get out and take that one next week. I wonder how many non-professional stock traders, common folk like me, actually trade like this? When watching CNBC one needs to remember whether one is a trader or an investor. Fast Money, Mad Money, buybuybuy – sellsellsell. “Start buying the financials because they haven’t been this cheep in decades”. I have been hearing that for months while they continue to decline. If I had a share of JPM for every time I heard that…. It seems no one wants to think about the lost revenue sources for the financials. All they talk about is write-downs – when will the write-downs be over. But when the write-downs are over, then what? How much of that precious fee income from the originate-and-distribute model will be coming back on line in the near future? How can they replace it with net interest income if they are short capital from the write-downs? What about fees from off-balance sheet commercial paper entities? What about the smaller regional banks that financed local real estate developers? Is now really the time to be buying financials with all of these unanswered questions? Not in my book, but I am a very nervous type of investor. I thought it was time to buy the financials in 2002 or thereabout when I purchased some JPM. I did pretty well with it and sold it in February 2007 because I got nervous. Sometimes it’s good to be nervous. I think there will be a time to get back in, especially JPM and perhaps BAC, but for me there are too many questions right now. In fact, there are so many questions that I went, and still am, short the financials in general. I may get burned, but I think it is a better play right now than going long financials. So far gains from this position have offset losses from long positions I have, so taking this position helps to hedge my little portfolio.

What is going on in the commodity markets? “The commodity play is real, it’s all caused by skyrocketing demand for global resources.” China, India, billions of new consumers. This skyrocketing demand suddenly happened over the past nine months? What about the past 5 years of global prosperity – wasn’t demand skyrocketing then? I don’t know, and I haven’t crunched the numbers, but if you step back and look at this objectively I think there is a lot of risk in those markets. Stocks down, treasuries and commodities up, and this is because of global demand? If that were the case then why are global stocks down and treasuries up at the same time? Wouldn’t global stock markets be up because of all of this global demand? Perhaps this is just the latest place for the “fast money” to park while the credit markets work out the current turmoil. Using the “how it feels” methodology I am afraid of commodities right now because it is possible that this is the next asset bubble to burst. That’s easy for me to say because I am not a big commodity investor anyway (in fact, I am not a big investor period). I’m sure there is some validity to the global demand story and, in fact, there have been articles in the press lately questioning whether a Malthusian catastrophe is in the works. So commodity prices should probably be on the rise, but the sudden skyrocketing of prices seems a bit overdone to this amateur, especially on the heels of what appears to be some serious economic weakness. Commodity prices are also being pressured by the falling dollar, but how much more does that have to go (better hope not much)? Of course, had I invested more in commodities I would have made more money, assuming I would know when to get out.

If you are living on a fixed income right now you are likely to be worried (unless of course it is a very large fixed income). Treasury and CD rates are very low and anything else in the credit markets is too scary right now, so how do you get income without risking your nest egg? This is one of the prices being paid for the orgy of debt we had over the past seven years. It seems counter intuitive at first that interest rates should be low (perhaps even negative in real terms) after we had a debt binge, but this is because the Federal Reserve has been flooding the markets with liquidity in the hopes of avoiding a major financial collapse while investors are bidding up the prices of treasury securities as they run for cover from riskier investments. So while it is not easy to get credit right now if you are looking to borrow, at the same time the typical safe investments for retirees and others on a fixed income are paying less and less interest. Perhaps some Fannie or Freddie securities or municipals make sense, although the tax advantage of municipals to investors on a fixed income may not be worth the low yields.

Oh yes, and there is inflation. I really don’t care what the CPI, PCE, PIG or SHI! say, filling up the car, the cupboard, and the heating oil tank have taken a much bigger bite out of my income on a percentage basis this year than any other in memory. That is inflation no matter what you call it. I was at the bagel store the other day and there was a sign up saying that due to the rise in the cost of flour bagel prices have been increased – a lot. The last time I started to see this kind of thing on a regular basis was back in the days of double-digit inflation. Not that we are having double-digit inflation now, but the memory is disturbing. Even if price increases slow down, they have already increased a lot.

So what do I do? I wish I had the “right” answer. I am still very nervous about where this whole credit crisis thing ends up. I did some reflecting and I decided that I needed to deal with the fear and greed issue. I thought about all of the credit market news and the financial bailouts, the falling real estate prices (sales were up some 2.7% in February – “maybe we are seeing a bottom!”), soft employment numbers (my most important indicator), and weak capital spending, and I decided that there is a lot of risk in all of the markets right now. Of course, when things are really bad is when you are supposed to have courage and get in, and countering all of the bad news is the totality of all of the Federal Reserve and federal government actions being taken to avoid a financial disaster. But when was the last time I though there was a real possibility of a financial disaster???? That’s enough for me – fear it is, today. The gains I may give up by sitting this one out are easily outweighed by the potential losses. So I have hedged my portfolio by reducing exposure to equities and going short on some general and selective indexes so that when the market goes up I don’t, but when the market goes down I don’t. I may also do a little gorilla trading here and there to try to juice returns as I can. The rest has been reallocated to those lousy-return safe investments like treasuries and FDIC insured CDs for now. As they mature I will be on the prowl for better returns, but with caution. Perhaps some high dividend yield stocks hedged with shorts on a lower yielding equity index. If I miss a big upswing in the stock market I will be less well off than had I been more aggressive and motivated by greed. If I miss a big drop I’ll feel really smart and then start buying. In the meantime I will keep watching all of those economic indicators, including the general tone and gyrations of the CNBC talking heads, as my “how it feels” indicator evolves.

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A Long Article about the Credit Markets

OK, here is my take on the current goings on in the financial markets. I want to preface this with the fact that this is not investment advise and it is my opinion. I do not have the time to provide backup for all of the numbers but they are readily available from current news sources. Where I don’t know the exact number I tried to be conservative. It is very difficult to try to boil this down to any reasonable length so a lot is left unsaid and what is said is meant to stress the risks we currently face. Many if not most professional economists believe we will have a mild recession and return to growth in the second half of 2008. That said, here goes:

1. The US has relied on foreign capital to support a large and long-term trade deficit. As we consume more than we produce, the net difference is imported from overseas. At the same time we export dollars to pay for these things we import. Those dollars often find their way back here in the form of investors looking for return. With all of these dollars looking for investments added to the normal amount of available investment capital, the markets work their way down the food chain. First they make good investments until those run out, then they make mediocre investments until they run out, then they make bad investments until the cracks begin to show as with the subprime mortgage meltdown. While this is going on the economy is booming because people are buying things, in fact, spending even more than they are making. Once investors realize they have made some very bad investments, however, they do exactly the opposite and run from these investments. Foreign investors take their money out of the US and bring it home or invest it elsewhere. This causes the value of the dollar to fall as everyone is trying to sell it in exchange for their own currency, and it reduces the amount of financing available to support asset prices and economic activity in the US.

2. As foreign investors pull their money out of the US and domestic investors run from financial assets prices of financial assets in the US fall because there is less demand for them. This is especially true when investors realize that the assets they invested in are not of the quality they expected. Mortgage backed securities, private equity buyout loans, and so on are all worth less than they were last year, not just because of defaults but because there is just less money around looking to buy these assets. This is referred to as re-pricing of risk. This flight to quality is seen in the dramatically low interest rates on Treasury securities that fall as demand for these safe investments increases – investors are selling riskier assets and purchasing safer ones. They are also purchasing hard assets as seen in the recent explosion of commodity prices.

3. As asset prices fall and capital flows out of the country and out of certain financial assets, banks begin to feel pressure. They need to raise funds to meet the demands of deposit withdrawals and to fund loans to customers who can no longer raise money in other markets such as the commercial paper market (again because the flow of money has reversed from in to out). Normally banks will borrow from other banks or depositors, and/or sell assets to raise the liquidity necessary to meet these demands. Today, however, they cannot do enough of either because they are all in the same boat and because there is a lack of demand for their assets – remember the capital is going out, not coming in. In order to sell assets and raise liquid funds the banks would be forced to take big losses on their assets, and that would reduce bank capital. The more they have to sell the lower the price they will get and the more bank capital is reduced. This could ultimately lead to insolvency of the banks, which is worse than illiquidity because it means that even if the banks had liquidity, they could not make any loans. No loans, investment plummets and employment follows. Of course, if this happens the loans on the banks’ balance sheets get even worse because as employment falls loan defaults increase in this downward spiral.

4. The Fed is using all kinds of tools, new and old, to prevent the system from collapsing under the weight of this de-leveraging (the term for when investors who provide capital leave the markets). First, it is lowering interest rates rapidly, with the federal funds target rate down from 5.25% in September to 3.0% now and another cut expected on Tuesday. Lowering interest rates is targeted at two things: lower rates in general means the rates on investments should go down and the re-pricing of assets should be less severe; and lower rates should support additional investment and consumption assuming those rates make it to the borrowers. The problem is that the lower rates are not making it to the borrowers and so the intended effect is not yet being felt. One reason this is happening could be that the banks are, in fact, insolvent based on current asset prices so they cannot make loans even if they have the liquidity. The other reason this could be happening is that the liquidity crisis is so severe that the banks are simply keeping up with their own balance sheet changes without making many new loans. Either way this is very troubling.

5. In addition to lowering interest rates, the Fed normally acts as lender of last resort to commercial banks. If a bank has a liquidity problem it can pledge collateral to the Fed and the Fed will then make a short-term loan to the bank through the discount window. This has also run into to trouble, however, because none of the banks want to borrow from the Fed this way. They are worried that if they do it will signal a problem and everyone will withdraw their funds from the bank – a classic run-on-the-bank scenario. To deal with this, the Fed created a new program called the Term Auction Facility, or TAF. Under this $100 billion facility the banks bid for loans from the Fed, and if they win they pledge collateral and get a loan for 28 days. The Fed has opened up the collateral pool to include basically anything the banks have to pledge (they can pledge anything they could have pledged for a discount window loan). The names of borrowing banks are not made public, and there is no schedule of the collateral the Fed takes to secure these loans released to the public.

6. The TAF was a very good idea, except it did not provide liquidity directly to the investment banks because they cannot borrow from the Fed without drastic action. In order to address this issue, last week the Fed announced a new $200 billion swap facility called the Term Securities Lending Facility. Under this facility an investment bank can give the Fed mortgage backed securities and other collateral and the Fed will give the bank Treasury securities from its own portfolio. The investment bank can then sell the Treasury securities for cash to get liquidity, and 28 days later it reverses the transaction by returning the Treasury securities for the collateral. Unfortunately this facility is not yet operational so it was too late for Bear Stearns. Bear experienced a run-on-the-bank Thursday and Friday of last week, and the Fed took that drastic action to lend directly to Bear Stearns through JP Morgan Chase. The Fed has not done this since the Great Depression.

So between lowering interest rates (the cost of funds to banks) and providing a source of liquidity (the loans and swaps) for the banks’ assets that are re-pricing, the Fed is hoping to avoid a major collapse of the system that could include runs on many institutions such as the one experienced by Bear Stearns last week. If the banks cannot raise liquid funds then they cannot meet the demands of depositors and borrowers and once this is known, there is a run on the bank. All told, the Fed has announced at least $400 billion in new facilities to provide liquidity to the banking system, which is about 44% of its entire balance sheet. Unfortunately interest rates to borrowers are still not declining signaling an even deeper liquidity crisis or an insolvency crisis. The falling dollar confirms the exodus of capital from the US markets and no one knows how far this will go. In the interim, the economy looks worse as banks do not extend credit for investment or consumption in large enough quantities to support economic growth. The very interesting and as yet unanswered question is what happens if the banks cannot repay the loans from the Fed and the pledged collateral ends up being worth less than the loan?

7. The Fed has a dilemma on its hands and there may be no solution available to it. On the one hand interest rates must be low to stimulate the economy by promoting borrowing and investment/consumption. If interest rates are high businesses will not invest and consumers will postpone purchases, so low rates traditionally help spur the economy. This is the standard policy response to a declining economy, and we are in a declining economy. On the other hand, however, low rates drive more capital out of the markets as it seeks better returns elsewhere. Witness the current boom in commodities, surely the next asset class to bubble over, and the continuing decline in the dollar. These trends are also leading to higher inflation as witnessed at the pump. So lower rates help to spur the economy and hopefully place some floor under the assets being re-priced, but at the same time chase away much needed capital (perhaps worsening the re-pricing because of lack of purchasers) and create a higher inflation risk. If the capital stays away because of the lower rates banks will not lend and we could have a severe economic downturn. Raising rates may help attract the much-needed capital, but it will slow the economy at a time when it is already vulnerable possibly resulting in a severe economic downturn. Therein lies the dilemma. It is very possible the Fed does not have a solution to the current problems.

8. Remember from number 1 above that this cycle of asset pricing and re-pricing was at least in part created by the unsustainable trade deficit of the US. The trade deficit reflects the fact that we have been consuming more than we have been producing, and paying for the difference by borrowing (and, in some cases, selling our assets). We have simply blown our credit beginning with the subprime mortgage meltdown, and it is now time to pay down some of the debt because our lenders are cutting off the flow of funds. That means a combination of selling our assets (as in Citigroup equity sold to foreign sovereign wealth funds) and saving. Saving is the opposite of consuming, so the more we need to save the less we can consume. The less we consume the lower the GDP, unless of course we cut all spending only on imports which is impossible, especially with our dependence on foreign oil. So I predict a fairly substantial slowdown in our immediate future as all of this works its way through the economy. If the flight of liquidity is severe enough we could also witness even more stress in our financial system, without which our economy comes to a halt. Because of this don’t be surprised if there is a large Federal bailout of the banking system on the horizon, regardless of what noise comes out of the White House about free markets and the like. If Bear Stearns is too big to fail so are all of the other major banks, both commercial and investment.

9. A taxpayer bailout of any magnitude is the last thing we need right now, especially with rising budget deficits, two wars, and ever increasing health care commitments. Tax increases may be unavoidable, even if they do further depress economic activity (though there is debate over whether this would be the case under these circumstances). The flight to commodities and resulting price pressure may or may not be sustained, depending in part on how long and how deep the economic downturn turns out to be. If the economy falls into a very deep recession, and especially if the global economy follows, we could see a reversal of the commodity price boom and, potentially, a period of deflation as all asset prices fall (this would be a worst case scenario).

10. How big of a crisis do we have on our hands? We can look at what the Fed and the Federal Government have done so far. At least $400 billion of liquidity facilities have been announced beginning in December and this does not include whatever loans have been made to Bear Stearns. Approximately $200 billion of mortgages have been funded by The Federal Home Loan Banks, an extraordinary increase on a historical basis. The FHA is in the process of refinancing defaulted subprime loans, and there are proposals in Congress to increase the total amount they can refinance to $300 billion. Congress and The President have passed an economic stimulus package estimated to cost approximately $160 billion. All the foregoing is taxpayer backed in one form or another. On the private side, banks have so far written off approximately $150 billion in losses on their assets and many expect another $135 billion to follow. Are we over $1.3 trillion yet? I think so. This sounds like a big problem.

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A History of The Great Economic Collapse of 2008

Looking back several decades at the economic downturn in the United States that began in the third quarter of 2007 and lasted for the better part of a decade, the causes seem predictable and inevitable. The United States had been consuming more than it produced for many years, running massive trade deficits. At the same time consumers were borrowing from international sources of capital to finance consumption, the United States Government was also running budget deficits, financing its expenditures largely from foreign investors and the retirement funds of the baby boom population – some 75 million Americans. Some of this over-consumption was funded through asset sales, especially after the initial decline in the dollar, as foreign investors thought they were getting bargains purchasing US assets.

The cracks in the system began showing up in earnest in 2007 with the great Subprime Mortgage Meltdown. This crisis in the subprime real estate market ultimately spread to the rest of the market and triggered an exodus of capital from the financial system as investors realized they had been taking on too much risk for the promised returns. Notwithstanding valiant attempts by the Federal Reserve to provide liquidity to the banking system, the risk re-pricing forced historic write-downs of assets on the books of the major banks, both commercial and investment, resulting in capital shortfalls at the major institutions. The first bank to experience a run was the 83-year old investment bank Bear Stearns, which was temporarily kept afloat through emergency loans from the Federal Reserve. This marked the first time such a loan was made since the Great Depression of the prior century. The resulting lack of financing into the economy drove investment to levels not seen in decades and unemployment soared. At the same time as the employment picture soured, many in the baby boom generation were retiring. Unfortunately the insolvency of the Federal Government resulting from tax cuts for the wealthiest Americans and deficit spending required massive cuts in health care and social security as well as large tax increases, further depressing the economy. A massive portion of the population retired into poverty.

In an attempt to fight both the re-pricing of assets and the lack of financing in the economy the Federal Reserve lowered interest rates dramatically, from 5.25% to 1%, at the same time inflation was running up. The interest rate targeted by the Federal Reserve at the time, the Federal Funds Rate, was negative in real terms for the second time in a decade. Unfortunately, these lower rates did not pass through to borrowers because the banks’ lack of capital prevented them from making loans regardless of how low their cost of funds was, and the fear of insolvency prevented banks from lending to one another which was how the system worked at the time. In fact, the monetary easing resulted in a further flight of capital as investors sold dollars to invest elsewhere where returns were better. The resulting fall of the dollar was also historic in nature as it hit all time lows against a basket of currencies week after week. This would have been a bright spot due to its impact on net exports, except that the decline in the US economy spread to the rest of the developed and developing nations reducing demand for exports.

Ultimately the Federal Government had to step in and bail out the financial system that had profited so handsomely for many years prior to the meltdown. The size of the bailout dwarfed the S&L bailout that was still visible in the rear view mirror, enraging much of the population. At the same time, those who had amassed fortunes during the boom years were able to acquire vast holdings of productive assets thereby widening the already large gap between the wealthy and the poor. Despite passing law after law and amending regulation after regulation in favor of the banking lobby for two decades, Congress professed shock at the actions taken by some of the major financial institutions during the ensuing hearings. The conflicts of interest of the rating agencies, the off-balance sheet accounting, the lax capital requirements, and several other issues resurfaced in the public view. Once the population at large learned that all of these issues had been brought to the attention of Congress years before, but ignored at the behest of the finance industry, there was a near revolt in the streets. This resulted in what we now refer to as the Great Political Restructuring.

Between the devaluation of the dollar and the massive infusion of funds to rescue the financial system inflation raged out of control for some time until the collapse progressed, after which deflation took hold as the world economy followed suit and demand for everything fell off globally. The lessons of this era remained strong and bank regulation was revised and strengthened. However, due to advances in technology and other systemic changes, the banking industry is now lobbying Parliament for additional powers such as combining their commercial and investment banking operations and allowing them to export interest rates from their home state to other states. They are also seeking reform to the bankruptcy laws and a declaration of Federal Preemption for protection from state regulators. Some argue that we should honor the lessons of the past and deny these powers to the banks, especially since the banks are ultimately backed by the taxpayers as lender of last resort. The neo-neo-conservatives, however, argue that the free markets will provide better competitive results for all consumers and the bankers, notwithstanding their incentives to take excessive risk, will adequately manage any potential risks to a systemic crisis. Paul Krugman, the sage economist now in his 98th year, declared such proposals outrageous and claimed they will lead the economy on a path to great divergence of wealth and the rebirth of the poverty population. Larry Kudlow, the underground talk show pundit whose age none can ascertain, pronounced this to be a great day for America, the likes of which he has not seen since the Great Political Restructuring. Time will tell which of these elder statesmen is still connected to the political economy and which is simply disconnected.

[Of course, I hope none of this is true and we see a rebound in the second half of 2008 as many predict. I just could not help having a bit of fun with this. I may do a serious analysis if time permits.]

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The F-LEF, or the Federal Reserve Liquidity Enhancing Facility

The Federal Government is in full swing on the current crisis in the financial markets. We have the FHA refinancing subprime loans and financing purchases with no money down (they claim 3% is required but this can be satisfied with a Seller’s Concession for closing costs, and we all know that’s code for raise the price to cover the concession); we have the Federal Home Loan Banks lending hundreds of billions of dollars to the banks on mortgage collateral; we have pressure on the GSEs Freddie and Fannie to step up their participation in the mortgage markets at a time when they are experiencing large losses themselves; we have the fiscal stimulus package (that, in part, increases the amount FHA and the GSEs can lend against homes from the high 300ks/low 400ks to $729k in many markets); and we have the Federal Reserve not only lowering interest rates but also providing $100 billion in liquidity for the banks through the new Term Auction Facility, or TAF. Wow! I have written on all of the foregoing steps taken to blunt the impact of the financial crisis that started with subprime mortgages except the TAF. You can find these articles by clicking on the “bailout” keyword on the list of keywords below. Today I want to look at this TAF.

Several months ago many commentators, including me, where writing about the Treasury plan to create a master liquidity enhancement conduit, or M-LEC. The purpose of this conduit was to be a buyer for assets that struggling SIVs, or structured investment vehicles, needed to liquidate. SIVs, at their core, take advantage of short-term financing at low rates to invest in longer-term assets that pay higher rates making a profit on the spread. When the short term funding dried up because of concern over the value of the assets held by SIVs they were forced to look elsewhere for funding or sell their assets. The problem was that the SIVs could not sell many of their assets into an unfavorable market without suffering losses on those assets. If they were sold at losses investors would suffer and the market could be permanently harmed. Enter the M-LEC that could purchase and hold these assets until the markets returned to “normal” and then sell them or simply hold them until maturity, thereby eliminating the need to sell them at a loss. Of course this raised accounting issues, among others, because if the market value of these assets was below the amount they were sold for the accounting really didn’t work. In the end the M-LEC was never formed. Instead, some banks that sponsored these SIVs ended up taking the SIV assets onto their balance sheets in order to avoid very embarrassing and reputation devastating results of SIV failures. Others were restructured into longer-term debt or liquidated at a hair cut to investors. (There were also liquidity lines from banks to these SIVs at stake, although the reporting on these was and is very confusing.) So in the end, the assets that caused the trouble ended up sold or on the balance sheet of the sponsoring banks.

Now enter TAF, or the Federal Reserve’s Term Auction Facility. This was introduced in December, around the time the M-LEC was originally to be finalized. The TAF is a loan facility from the Federal Reserve to banks. The Federal Reserve has been increasing the amount of the TAF facility in the aggregate from an original $30 billion to $60 billion, and last week to $100 billion. Here is what it does. Bank A needs liquidity to meet deposit withdrawals and/or loan commitments. It can try to get more deposits if it can, but apparently the banks can’t. It can borrow from other banks, but apparently the banks don’t want to lend enough to each other right now either. It can sell an asset on its books to raise liquidity, although this would reduce its profits by shrinking its balance sheet. Or, perhaps it can’t sell an asset on its books to raise the needed liquidity because the market value of the assets is below the carrying value and Bank A would take a loss. Hum, food for thought.

Enter the TAF, where Bank A can pledge assets to the Federal Reserve in exchange for a loan as long as 28 days in duration. Problem solved, Bank A has the liquidity it needs and the markets are not flooded with assets no one wants to purchase. All of this has me wondering – has the Federal Reserve become the Master Liquidity Enhancing Conduit that the banks and Treasury could not work out? The amount, about $100 billion, seems about right. The timing seems about right. It walks and talks like a duck, so maybe it is. I call it the F-LEF, or the Federal Liquidity Enhancing Facility.

The next question that follows is what assets is the Federal Reserve taking against these $100 billion in loans to the banks? Are they those same assets that moved from SIVs and perhaps other asset backed commercial paper conduits sponsored by the banks to the balance sheets of the banks? Seems like a very logical sequence of events viewed this way, so I decided to try to verify whether this was in fact the case. (The banks can pledge collateral that includes mortgage-backed securities, even ones that may contain subprime mortgages). Unfortunately, the Federal Reserve has not, to my knowledge, published a schedule of the collateral it has taken for these loans. So, the usually transparent Federal Reserve has hit a wall of opacity. It is not publicizing which banks are borrowing and it is not disclosing what assets are being pledged against those loans.

I, for one, would like to know what collateral the Federal Reserve is accepting and how it is being valued. Until these facts are made public, I will assume that the Federal Reserve has done what the M-LEC failed to do by creating the F-LEF through which the banks are delaying sales of assets that have been negatively impacted by the changing markets in order to preserve liquidity (or is it the appearance of solvency?). At the same time the banks are being openly encouraged to raise additional capital. So just how solvent are the banks?

Some very interesting questions and issues have been raised by this TAF. On the one hand, some commentators believe it could be the first step to nationalizing the banks (see this article by Steve Randy Waldman). If there are margin calls on the collateral that the banks cannot meet, what is the Federal Reserve to do? Convert the loan to equity? Interesting point. One colleague of mine suggested the Federal Reserve could simply forgive a portion of the debt, or “write it down”, just like the Federal Reserve Chairman Ben Bernanke is suggesting lenders should do with mortgage loans that are more than the property values securing them. That would raise a lot of very interesting issues. Others have said this is just a more effective way to provide needed liquidity to the banking system and should be well down the list of current concerns (see this article by Caroline Baum in Bloomberg).

Stay tuned – I have a feeling this isn’t over yet.

(Ordinarily banks that are solvent can borrow from the Federal Reserve using the Discount Window. The TAF is different in several ways. First, the Federal Reserve will not publish the names of the banks that win the auctions so we just don’t know which ones they are. These loans are also much longer in duration at 28 days and the Federal Reserve has assured the markets that it will provide these lines of credit for at least six months unless market conditions clearly show they are no longer needed and will increase the size if necessary. In the Federal Reserve’s words:

First, the amounts outstanding in the Term Auction Facility (TAF) will be increased to $100 billion. The auctions on March 10 and March 24 each will be increased to $50 billion--an increase of $20 billion from the amounts that were announced for these auctions on February 29. The Federal Reserve will increase these auction sizes further if conditions warrant. To provide increased certainty to market participants, the Federal Reserve will continue to conduct TAF auctions for at least the next six months unless evolving market conditions clearly indicate that such auctions are no longer necessary.)

For more details about the TAF visit the Federal Reserve's website.

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