Look Back, Look Forward

December 29, 2019

By Steve Stofka

In this last week of 2019, I’ll look way back for a bit of perspective heading into the coming election year. In 1932, voters elected FDR to the Presidency. More significantly, they elected an overwhelming majority of Democrats to the Congress to enable FDR to make big changes. Voters wanted an activist government to fix things.

$2.8 trillion is a lot of money, about 2/3rds of what the federal government spent in 2018 (CBO, 2019). That’s how much inflation-adjusted money depositors lost in bank failures during the Great Depression (Investopedia, n.d.). Imagine if ¾ of all the cash and money in checking accounts just vanished. That’s $2.8 trillion.

The Federal Deposit Insurance Corporation was created in 1933 to protect bank depositors from the loss of their life savings. During the 2008 Great Financial Crisis, Washington Mutual had losses of $307 billion. Depositors lost nothing. That’s activist government.

Republican advocate for a reactive rather than a proactive government – one that has a light regulatory hand. Too often this type of government ignores signs of trouble until a full-blown crisis develops like the 9-11 terrorist attacks or the Great Financial Crisis.

Voters will be asked to decide on which government role they prefer. Advocates for an activist government believe in grand communal solutions, many of which are poorly executed but are better than nothing. Cars, phones, computers and the social media that dominates our public policy discussions were all privately developed solutions that have adapted quickly to user demands. Government solutions are clunky contraptions of conceited ambitions that are slow to evolve as effective solutions. When they finally achieve some efficiency, the problem has changed. Examples include rent control, Social Security, Medicare, and the federal student loan program.

Advocates for a reactive government wait until the situation is near crisis levels, see that no one has created a solution yet and propose a public private partnership (PPP). These programs are not well designed to solve the problem but serve the purpose of funneling public tax dollars into private coffers while policy makers pontificate about free market solutions.  Examples are prisons, toll roads, and university student housing.

Presidents are usually elected for a second term. President H.W. Bush lost his bid for a second term in 1992 because of the lingering effects of a recession.  In 1980, President Jimmy Carter lost his bid for economic reasons as well. Divisions in the Democratic Party over the Vietnam War convinced an unpopular President Lyndon Johnson that he should not run for a second term in 1968. It’s unlikely that we will have a recession next year and that will increase the likelihood that Mr. Trump will be re-elected. Will that influence your financial decisions in any way?

The SP500 has gained 41% since President Trump took office in January 2017. Most of that gain has come in the past year. A record amount of money flowed into equity ETFs in December (Bell, 2019). Are investors chasing the high? Now is a good time for older investors to evaluate the risk-reward profile of their portfolio. An unpleasant task is to imagine what choices you might need to make if the value of your equity holdings were cut in half. That’s what happened in 2001-2002 and again in 2007-2009.  

97% of the U.S. is classified as rural but only 20% of the population lives there (Census Bureau, 2016). The map of the country may be colored a political shade of red, but there are relatively few voters per county. An ever-increasing portion of the people live in the scattered blue and politically purple areas. For decades the children who grew up in rural communities have left and not returned. The political fight for the direction of the country is not between rural and urban populations but between voters in smaller metro areas and suburban communities (Marema, 2019).



Bell, H. (2019, December 20). ETFs See Record $52B Inflows. [Web page]. Retrieved from https://www.etf.com/sections/weekly-etf-flows/weekly-etf-flows-2019-12-19-2019-12-13

Census Bureau. (2016, December 8). New Census Data Show Differences Between Urban and Rural Populations. [Web page]. Retrieved from https://www.census.gov/newsroom/press-releases/2016/cb16-210.html

Congressional Budget Office. (2019, June 18). The Federal Budget in 2018: An Infographic. [Web page]. Retrieved from https://www.cbo.gov/publication/55342

Investopedia. (n.d.). Bank Failures. [Web page]. Retrieved from https://www.investopedia.com/terms/b/bank-failure.asp

Marema, T. (2019, March 14). Contrary to What You Hear, the Rural-Urban Gap Didn’t Grow in 2018 Election. The Daily Yonder. [Web page]. Retrieved from https://www.dailyyonder.com/contrary-hear-rural-urban-gap-didnt-grow-2018-election/2019/03/14/

Majksner, Nikola. (n.d.). The Battle of Sutjeska Memorial Monument Complex in the Valley of Heroes, Tjentiste, Bosnia and Herzegovina. [Photo]. Retrieved from https://unsplash.com/photos/as_pS7EkK-Y

The Force of the Fed

To some extent, the Federal Reserve considers itself government. Other times, when it serves, it considers itself not government. – Philip Coldwell, President FRB Dallas 1968-74

September 2, 2018

by Steve Stofka

The nations of the world are the gods of Mt. Money, most of them with central banks who administer the credit and currency of each nation. Like the ancient Mt. Olympus of Greek lore, there is competition and a hierarchy among the gods. Currently the U.S. is the top god of Mt. Money.  Central banks manage credit by changing the interest rate, or price, that they will charge the demi-god banks within the nation’s borders. The banks, however, do not perfectly distribute the intentions of the central bank. Acting as intermediaries, the banks filter monetary policy and have a more direct effect on the economy. In this intermediary role, banks control the draining of Federal taxes generated by the economic engine.

In the U.S., the Federal Reserve (Fed) is the central bank of the Federal government, an independent agency created by Congress which has given it two targets: promote full employment and stable inflation. To meet those goals, Fed economists must gauge the strength of the economy, a difficult task, and estimate an ideal state of the economy, an even more difficult task.

Each August the Federal Reserve holds an economic summit at Jackson Hole in Wyoming. The newly appointed head of the Federal Reserve, Jerome Powell, is the first non-economist leading the central bank in 39 years. His paper (Note #1) is plain spoken and illustrates the difficulty of reading an economy in real time. As such, I think he will be a gradualist, someone who advocates measured moves in interest rates unless there is a more abrupt shift that requires a stronger policy tonic.

Powell uses the analogy of a sailor steering the waters by reading the stars. The waves and weather can make real time observations unreliable, yet the sailor must make decisions that steer his course. Optimizing employment is one of the two missions that Congress has given the Federal Reserve. The Fed must make a real-time estimate of what they think is the optimum or natural rate of unemployment (NAIRU) and adjust interest rates to help align the actual unemployment rate to the natural rate. Powell presented a chart that compares the actual rate of unemployment to NAIRU as it was estimated at the time, and the “hindsight” NAIRU as economists now calculate it. (Note #2) The speech balloons are mine.


On page seven, Powell writes that, in the past, the central bank “placed too much emphasis on its imprecise estimates of [NAIRU] and too little emphasis on evidence of rising inflation expectations.”

Note the final word – expectations. Measuring what will happen is especially difficult because it has not happened. Probability methods can help but an economy has many more inputs than a dice game. One category of estimates are surveys of guesses about what will happen in the future, but these overstate actual inflation [Note #3]. A second category uses market prices. One method uses the price that buyers are willing to pay for a Treasury Inflation Protected Security (TIPS) (Note #4) In my July 22nd post, I introduced another market method – the net flow of money into the economic engine (Note #5)

Credit expansion has been poor since the Financial Crisis. The Fed cannot force banks to increase or decrease their loan portfolios by changing interest rates. In the years following the Financial Crisis, the Fed was frustrated by this inability, called “pushing on a wet noodle.” Interest rates are the carrot. The stick is a complex regulatory process that raises or lowers asset leverage ratios to encourage or discourage lending (Note #6).

The Fed manages credit flow through asset sales and purchases. While the central banks of other countries can buy stocks and commodities, the Fed is limited to buying debt, including foreign currencies, from its member banks (Note #7).

The Fed has the extraordinary power to purchase or sell the reserves of its member banks without their consent. Like the Fed, you or I can increase the reserves of a bank by depositing money in the bank (Note #8). What we can’t do is lower those reserves by writing our own loans. However, credit card companies, who are underwritten by banks, do provide us with a line of credit that we can draw on by using our cards. During the Financial Crisis, credit card debt jumped $50B, or 15%, because card holders reduced their payments by that much. In response, credit card companies reduced credit card limits by 28% (Note #9). While the Fed encouraged banks to loan, the behavior of consumers and businesses did the opposite. Consumers and businesses were more powerful than the Fed.

The banks administer or filter Fed policy in their interactions with consumers and businesses. If a bank must pay higher interest for its funds, then it will charge higher interest rates for consumer and business loans. Interest is the price for a loan. When the price rises, the supply for loans rises (banks make more profit on the spread) but demand for loans falls. The reverse is not true, as the data of the past decade has shown. When the price falls, the supply of loans falls while the demand increases.

Less credit expansion results in a slower economic engine, which generates less Federal tax revenue. For the engine to run properly, the internal pressure must remain stable. Inflation is one gauge of that internal pressure. The annual growth in Federal tax revenue must be equal to or greater than the inflation rate. When it is not, the engine begins to stall. In the graph below, I’ve charted the annual growth in Federal tax revenue less the inflation rate. Note the periods when this metric dropped below zero. In most cases, recession follows. Look at the right side of this chart. There has never been a time when the reading is so far below zero without a recession. That is a cautionary note.


The Fed must look through the fog of the future before it deploys its money super powers. In the face of this, the Fed must act with humility and a practical caution. Once it has decided on a strategy, the banks modify its implementation because they obey three masters: the Fed, their customers and their stockholders. Actual monetary policy becomes not the work of a select few in the Federal Reserve but an emergent composite of policy force and practical friction.


1. Powell’s speech is 14 pages double-spaced with several pages of charts and references.

2. For thirty years, from 1955 to 1985, the gap between the real-time estimate of NAIRU and the hindsight estimate is 1-1/2%, an error of 25%. In the 1990s economists’ models were more accurate. The estimate of NAIRU and its validity is debated now as it was in 1998 when Nouriel Roubini referenced several views on the topic.

3. A one-page Fed article on survey and market methods of measuring inflation expectations.

4. A one-page Fed article on long-term inflation expectations using the implied rate of TIPS treasury bonds – currently it is 2.1%. Vanguard article explaining TIPS bonds.

5. The net flows of credit growth, federal spending and taxes precedes inflation by several months (July 22 blog post).

6. Credit growth has been flat for the past decade as I showed in this July 15th post.

7. In conjunction with the Treasury, the Federal Reserve may buy foreign currencies to correct disruptive imbalances in interest rates. A NY Fed article explaining the process.

8. When we deposit money in a bank, its reserves, or cash balance, increases on the asset side. It incurs an offsetting liability of the same amount because the bank owes us money. We have, in effect, loaned the bank money. When so many banks collapsed before and during the Great Depression, people came to realize the true nature of depositing money in a bank. The banks could not pay back the money that depositors had loaned them. The creation of the FDIC insured depositors that the money creating powers of the Federal government would stand behind any member bank. My mom grew up during the Depression era and passed on the lessons learned from her parents. She would point to the FDIC Insured decal on the bank window and tell us kids to look for that decal on any bank we did business with in the future.

9. Credit card companies lowered limits. See page 8. Oddly enough, this Fed study found “we have little evidence on the effect of such large declines in housing wealth on the demand for debt.” Page 9. NY Fed paper written in 2013.

Hunt For Inflation

July 15, 2018

by Steve Stofka

Saddle up your horses, readers, because we are going on the Hunt for Inflation. I promise you’ll be home for afternoon tea. During this recovery, Inflation has been a wily fox, a real dodger. It has not behaved according to a model of fox behavior. Has Inflation evolved a consciousness?

Inflation often behaves quite predictably. The central bank lowers interest rates and pumps money into the economy. Too much money and credit chasing too few goods and Inflation begins running amuck. Tally-ho! Unleash the bloodhounds! The central bank raises interest rates which curbs the lending enthusiasm of its member banks through monetary policy. Inflation is caught, or tamed; the bloodhounds get bored and take a nap.

Not this time. Every time we think we see the tail of Inflation wagging, it turns out to be an illusion. Knowing that Inflation must be out there, the central bank has cautiously bumped up interest rates in the past two years. Every few months another bump, as though unleashing one more bloodhound ready to pounce as soon as Inflation shows itself.

Yes, Inflation has evolved a consciousness – the composite actions of the players in the Hunt. These players come in three varieties. One variety is the private sector – you and me and the business down the street. The second variety is the federal government and its authorized money agent, the Federal Reserve, the country’s central bank. Finally, there is a player who is a hybrid of the two – banks. They are private but have super powers conferred on them by the federal government. The private sector is the economic engine. The federal government and banks have inputs, drains and reservoirs that control the running of the economy.

The three money inputs into the constrained (see end) economy are 1) Federal spending, 2) Credit growth, and 3) net exports. In the graph below, the blue line includes 1, 2, and 3. The red line includes only 1. The graph shows the dramatic collapse of credit growth in this country. Federal spending accounted for all the new money flows into the economy.


Before the financial crisis, money flows into the economy were just over 30% of GDP. In less than a year, those inputs collapsed by almost 25%.


When inflation is lower than target, as it has been for the past decade, too much money flow is being drained out for the amount that is flowing in. In the case of too high or out of control inflation, as in the case of Venezuela, the opposite is true. Too much is being pumped in and not enough is being drained out. That’s the short story that gets you back to the lodge in time for a cup-pa or a pint. Next week – the inputs, drains and reservoirs of the economy.


  1. Constrained – the private economy, state and local governments who cannot create new credit.
  2. Net exports are the sum of imports (minus) and exports (plus).

Manufacturing Miracle Coming Soon

August 21, 2016

In the olden days, like the late ’90s and early ’00s, it was a good thing that America was ridding itself of heavy manufacturing industries. They were, like, so 20th Century, man.  We were entering a new century of computers, the internet and high tech manufacturing.  Compaq Computer, Sun Microsystems (Java), Microsoft, Oracle (databases), and Apple expanded in Massachusetts, Colorado, California and N. Carolina.  Bye, bye old smoke belching industries and hello new clean room high tech industries.  America was becoming a knowledge and service economy.  Let those third world countries like Mexico, China and Thailand make stuff and pollute their cities, and ship the finished products to our shores.

Wind the clock of history to the present day and we are having a markedly different discussion.  Donald Trump, the Republican candidate for President, vows to bring old time manufacturing back to the U.S.  Under pressure from the leftist wing of the Democratic Party, Hillary Clinton pledges to kill the Trans-Pacific-Partnership (TPP) trade agreeement in its present form. The theme of this election: jobs and security.

Remember the billionaire Ross Perot who ran for President in the 1992 and 1996 elections?  Ross and The Charts.  Sounds like a Motown group.   While Perot didn’t get any votes in the electoral college, 20% of voters pulled the lever for him and probably pulled most of those votes away from George H.W. Bush, the incumbent Republican President in the 1992 election.  Bill Clinton won that one with the lowest popular vote in history and may send Mr. Perot a Christmas card each year as a thank you.  Perot said that if NAFTA passed – and it did pass in 1993 – there would be a big sucking sound as jobs were vacuumed from the U.S. into Mexico. In the late 90s, not too many companies had moved to Mexico yet.  The high tech and internet booms were in full swing and the unemployment rate was less than 5%.

 No big suck until…

In 2001 China was admitted to the World Trade Organization (WTO).  Put into a big pot a lot of cheap labor, eager urban planners in China, and lax environmental regulations.  Stir vigorously.  A black hole forms that sucks jobs from America and other developed countries.

From 2000 to mid-2008, before the financial crisis, manufacturing industries lost four million jobs.  Almost 25% of the work force gone in just eight years.  The transition from manufacturing had been going on for several decades but at a much slower pace.  In the previous twenty-two years, from 1978 to 2000, the manufacturing work force fell by two million.  As more product manufactures moved to China and southeast Asia in the 2000s, the job loss rate was five times what it had been in those two decades.

Manufacturing is a stew of many ingredients called the supply chain.  The chain includes the companies that make parts and tools for big industry as well as the transport needed to get raw materials to these suppliers.  It includes the housing, schools, shops and hospitals for a large regional work force.  Donald is going to bring that huge infrastructure back.  All by himself.  Yay for Donald.


Franklin D. Roosevelt and the Banking Panic of 1933

Two days after FDR took office in March 1933, he declared a national bank holiday, shutting the nation’s banks for a week.  For a month before FDR took office, depositors had been withdrawing their money from banks in a concerted panic.  The conventional narrative is that FDR’s quick action saved the banking system from a certain collapse.  But wait, there’s more.  Why were people in a panic?

In order to win the election in November 1932 against the incumbent Herbert Hoover, FDR used a familiar tactic – scare the voter.  In the midst of the Depression, this wasn’t difficult.  Britain had gone off the gold standard in 1931 and American confidence in their financial institutions and their very currency was sorely tested. FDR’s oratorical and theatrical skills helped convince many voters that only an FDR presidency could rescue the American family.

In those days, a new President did not take office until March of the year following a November election. Soon after FDR was elected, people began to fear that he would devalue the dollar once he took office. En masse, people wanted to trade in their dollars for gold or something that could be converted to gold. In the first months of 1933, states began to declare bank holidays to halt the wave of withdrawals but the panic caused many more banks to fail. (A detailed account of the bank panic)

When FDR took office, 35 states had declared bank holidays of various extent.  FDR made the bank holiday a national one that included the reserve banks.  In the ensuing week people grew more confident as they realized that FDR would not devalue the dollar and that the Federal Reserve would guarantee all deposits until a national insurance program could be enacted.  When the holiday was over, people began to return the hoarded money to the banks. To sum it up, FDR’s quick action helped alleviate the panic which was started in part by FDR’s election.  Here’s a more complete account from the FDIC    I wish history was more like the simple version found in our grade school history books.

Income and GDP

March 30th, 2014

Business Activity

The Institute for Supply Mgmt (ISM) and Markit Economics are two private companies that survey purchasing managers and release the results in the first week of each month. Toward the end of each month Markit releases what is called a “Flash PMI”, an early indication of activity for the month.  This month’s flash index of manufacturing activity declined slightly but is still showing strong growth.  New orders are showing strong growth at a reading of 58.  The Flash reading of the services sector rose to over 55 but this is a mixed report, with only tepid growth in employment and backlogs actually in a slight contraction.  The most remarkable feature of this report was the 78.1 index of business expectations, an outstandingly optimistic reading. This Flash index gives investors a glimpse of the full survey reports from ISM and Markit that will be released in the first week of next month.


On the other hand…

The monthly report of durable goods indicates a rather tepid 1-1/2% year over year growth.  This excludes planes, autos, and other transportation orders.  Including those components, there has been no yearly growth.


Stick with the plan, Stan…

Rising equity and real estate markets have been good for a lot of people. A Bankrate.com blog noted the number of people entering the ranks of millionaires in 2012.  Toward the end of this report was an important lesson: “60 percent of investors worth $5 million or more say they’ll invest in equities this year, while 31 percent of those worth $100,000 to $1 million plan to do the same.”  Hmmm…rich people are not buying into the prophecy prediction analysis that the market will crash this year.  Could they be sticking with a plan that  allocates investments across a variety of assets, including stocks?


Personal Income

This week, the Bureau of Economic Analysis (BEA) released February’s estimate of personal income.  Real, or inflation adjusted, disposable personal income (DPI), rose 2.1%, a decline from January’s 2.75% increase but above the 1% that has historically led to recessions.

A few weeks ago I noted that annual DPI had dropped below 1% in 2013.  Contributing to the weak year over year comparison was the high spike in income in the fourth quarter of 2012 when many companies “paid forward” both dividends and bonuses in December in advance of tax increases scheduled for 2013.

While this may have been a contributing factor to the decline, it would be a  mistake to give it too much weight.  The growth in personal income has been relatively weak and it shows in the consumer spending index released this week.  The .1% year over year increase – essentially zero – indicates consumer demand that is too weak to put any upward pressure on prices.  Sensing this, businesses are less likely to invest in growth.  Less investment growth means that employment gains will be modest, which further reinforces modest economic growth.

The stock market trades on profit growth.  Standard and Poors reports that 4th quarter earnings for the companies in the SP500 rose 9.8%, accelerating from the 6.0% growth in the 3rd quarter of 2013.  A moderately improving economy and only modest growth in investment has helped boost profits.  Profits are expected to rise 11% in the second half of 2014.



The third estimate of GDP growth in the fourth quarter of last year was 2.6%, in line with consensus estimates.  In her testimony before Senate Finance Committee two weeks ago, Fed chairwoman Janet Yellen noted that we may be in for an extended period of slow growth below the fifty year average of 3%.

Three weeks ago I looked at GDP and the personal savings rate.  This week I’ll look at per hour GDP.  Readers should understand that this is what some economists would call a messy data set.  I have made some assumptions about the number of hours worked per employee.  The BLS publishes average hours worked for manufacturing employees and I made a guesstimate that the average for all workers is about 90% of that.  The number of part time employees who do not work this amount of hours offsets the unreported hours of the self-employed.  I am less concerned about the absolute accuracy of the GDP output per hour worked but that any inaccuracies be fairly consistent.  The trend is more important than the actual numbers.  What can we learn when output per hour flattens or declines?  Below is a graph of sixty five years.

We can see that flat growth tends to precede recessions but there is no definite pattern where we can say with any confidence that a flattening or decline in per hour GDP necessarily precludes a recession.  If we zoom in on the past thirty years, we do notice that the preceding decade has been marked by long periods of flat growth.  More importantly, the recovery from this past recession is marked by the longest period of flat growth in the history of the series.

The summer of 2009 marked the official end of this past recession.  For five years there has been no increase in real GDP per hour worked.  For a few years following a recession in the early 1990s, per hour GDP flattened before taking off in the late 1990s.

Does this flat growth represent a pruning of the economic tree before a surge of new growth? Or does it presage an even worse recession? Is the economy locked inside a limbo of limp growth for years to come, echoing the two decades of little growth in Japan’s economy?  Whatever happens, we can be certain of one thing – the trend and pattern will be so much more obvious in the future simply because we will disregard some past data based on what happens in the future.

As we make investment decisions, we should remember that the “obvious” patterns we see when we look back were much less clear at the time.  Sure there will be investment gurus who tell us that they saw it coming.  We forget that they also saw the depressions of 1994, 1998, 2000, 2004, 2006 and 2011 – the ones that didn’t happen.

Let’s look a bit more closely at recent periods of flat growth.  The recovery from the recession of 1991 was marked by a painfully slow recovery in the job market.  After a 30% rise over three years, the market stumbled.

There’s a story to be told when we look at the growth in the market index and per hour GDP.  Whether it is by coincidence or not, there is a loose response of the market to changes in output.

After another slow recovery from the recession of 2001, the market began to climb in 2004.

But this time the market was not responding to the flattening growth in per hour output.

In the past four years, there has been little growth in output per hour.

But the market has doubled over that time.

Part of that recovery can be attributed to the market simply reversing the decline of 2008 and early 2009, but a good 40% increase in market value can be attributed to the greater share of output that companies have been able to convert to profit. (See last week’s blog)  How long that trend can and will continue is anyone’s guess but we know that it can not go on forever.  Flat revenue growth makes growing profits an ever more difficult task.

The flat growth in per hour output gives us perhaps another insight into the so-so growth in employment.  Without a clear vision of a stimulus that will spur growth, companies are reluctant to commit to plans for an expansion of their work force.

Out Of the Tent and Into the Forest

May 12, 2013
We can take some steps to reduce our susceptibility to adverse events but if our primary aim is to reduce uncertainty as much as possible, our lives suffer in quality and our wallets suffer in quantity.  In our financial lives, we must try to find a balance between risk and reward.  There is a high demand for low risk, high reward investments.  Unfortunately, there is little supply of such investments and the few that are offered are usually scams.

There is a good supply of low risk, low return products. In the past ten years, conservative savers have taken a beating.  There have been only two periods where the interest on one year CDs has exceeded the percentage increase in inflation.

Challenged by low interest rates on CDs, savers have fled the market.

Older people who rely on their savings to generate income continue to search for yield, or the income generated by an investment.  The iShares High Yield Corporate Bond ETF, HYG, and the iShares Dividend Select Index ETF, DVY, have posted strong gains.  As more investors chase yield and drive up prices, the yields correspondingly become lower.   In December 2007, DVY paid out an annualized 4.7% yield on a price of about $53.  In March 2013, the yield was 3.4% on a price of $65 (Source)

Despite the fact that the Federal Reserve has held interest rates at historic lows, the amount of household savings continues to climb.  Some of this is due to an aging population which has more in savings and tends to be more conservative.

The Federal Reserve is essentially kicking people out of the tent and into the forest where the wild animals live.  It’s risky out there in the forest.  How come the banks don’t want our money?  Some people do not realize that a CD or savings account is essentially a loan to the bank.  Through the FDIC, the U.S. government insures most of these loans.  Loan your brother in law money for a  year and you might not get it back.  Loan your bank the money and you are assured that you will get it back.

In the simplified models of banking we learned in grade school, the bank pays us interest for the money we loan it (deposits) and loans that money out to other people at a higher rate of interest.  The difference in the two interest rates is how banks pay their employees and other business costs and make a profit. The reality is much more complex.  A bank does not take a $10 deposit from Mary and loan it to Joe.  The bank takes the $10 deposit from Mary and loans $100 to Joe.  Where did the other $90 come from, you ask?  It is created out of thin air in a process called fractional reserve banking, which allows a bank to leverage the $10 deposit by ten times, in this example.  Because banks are leveraging money, there is a labyrinth of financial metrics of stability to insure that the banks are not taking too much risk.  Some of these metrics include the risk weighting of assets (deposits, loans and securities, for example) and capital asset ratios.

In a 1985 paper by Federal Reserve economists, they note that “There is remarkably little evidence, however, that links the level of capital or the ratio of capital to assets with bank failure rates.”  This paper was written before the S&L crisis of the 1980s.

The financial crisis in 2008 led to a surge of bank failures, peaking at more than 150 in 2010.  In this past year, failures have dropped to a level that can be counted with two hands.

 During the recession, the amount of commercial and industrial loans declined but have risen to nearly the same level as 2008.

From a thirty year perspective, we can see just how severe the decline was.

While loans and interest bearing accounts, or assets, at the largest banks are nearing 2007 levels, assets at small banks have declined.

The banking industry has been consolidating, larger banks eating up the smaller ones.

This past Friday, the Chairman of the Federal Reserve, Ben Bernanke, expressed concern that some of the larger banks are still prone to failure.  The ever increasing size of the big banks has enabled them to have an even greater voice in the halls of Washington.  Bernanke’s remarks hint that he is a proponent of further regulations which would reduce the amount of leverage that banks can use to increase their profits.  Banking industry lobbyists are making the case that if they are required to reduce their leverage, it will hurt the economy by reducing the amount of loans they can make.

The banks are feeling squeezed and they are sure to let lawmakers know.  Their net interest margin, or the spread between what they pay to depositors and what they charge to borrowers, has fallen to pre-recession levels, putting pressure on banks to take more risk to increase their bottom line.

I am reminded of a comment made by Raymond Baer, chairman of Swiss private bank Julius Baer, in 2009 who warned: “The world is creating the final big bubble. In five years’ time, we will pay the true price of this crisis.”  Let’s see: 2009 + 5 = 2014.  Hmmmm….

But we can’t live our lives waiting for the next catastrophe.  We must take some risk, be diversified and be vigilant.  As the stock market reaches new highs with each passing day, more investors will reassess their risk profile.  Some will curse their caution of the past few years and move money from safe but low yielding assets to the market, helping to fuel rising market prices.  The demand for yield creates a feedback loop that actually makes it harder to achieve yield.  If only we could live in a world where they didn’t have these darn feedback loops.

JPMorgan Hedge Update

This weekend the Wall St. Journal had more details about the large gamble/hedge that JPMorgan (JPM) has taken in a derivative index called IG9 that tracks the overall health of corporate bonds. The full value of JPM’s position is about $100 billion or about 78% of the firm’s entire market cap.  Other hedge funds are waiting for JPM to start unwinding their position, aiming to profit at JPM’s expense.  Some estimates are that JPM’s losses could run as high as $6 – $7 billion.

In my blog yesterday, I stated that JPM had about 150 regulators working on site, supposedly supervising JPM’s operations to ensure the public safety.  The Office of the Comptroller of the Currency (OCC) revealed that they had 60 regulators who did nothing but monitor JPM’s trades and were aware of these highly aggressive trades.  As of late April, those regulators evidently saw nothing unsafe in JPM’s trading positions.  Do those regulators still have their jobs?  Probably.

The Federal Reserve and the FDIC also have onsite regulators who monitor JPM’s activities.  So many regulators and no cause for alarm before this blew up?  The Senate Banking Committee has started an investigation into this debacle.  In the political merry-go-round, we can expect more hearings, more regulations, more regulators, more cost to the taxpayer and less safety, less effectiveness from our government.

JPMorgan Hedge

The recent scandal involving JP Morgan’s hedging loss of $2.3 billion (and is growing by $100 to $150 million per day),  has refocused attention on the Volcker rule, a key provision of the 2010 Dodd-Frank bill that initiated a new set of regulatory restrictions on the banking industry.  At more than 800 pages, the law spawns millions of new regulations, many of which won’t be finalized until July of this year, when the Federal Reserve is to start supervising the banking industry to bring them into full compliance with all the regulations by 2014.  The Volcker rule was ostensibly designed to curb the gambling type of hedging that brought the banking industry and the economy to its knees in 2008.  The JPMorgan fiasco has ignited a debate among politicians and pundits, bankers and regulators as to whether this trading strategy would have fallen under the purview of the Volcker rule.

As always, the devil is in the details.  Section 619 of a draft version of the bill stated that banks might initiate hedging trades “in connection with and related to individual positions.”  The banking lobby wanted to insert two small words “or aggregated” so that the final version of the bill would read “in connection with and related to individual or aggregated positions.”  They may have argued that banking and/or investment firms do aggregate a position over time through a series of trades, a common practice to avoid “moving the market” with a single large trade.  This, in fact, is the final language of the Dodd-Frank law (pg. 249)
Some argue that these two simple words effectively negates the effect of the Volcker rule because it allows an investment bank to engage in any hedging strategy as a tool to ameliorate the risk of any portion of the banks portfolio of investments.  The entire bank’s portfolio is, after all, an aggregated position in the market.  In effect, the language of the law allows investment banks to engage in the same kind of risky bets that the Dodd-Frank law is supposed to curtail. Jamie Dimon, the Chairman and CEO of JP Morgan, insists that the failed hedge would not have fallen under the Volcker rule.  There are about 150 bank regulators who work in the home offices of JP Morgan, constantly monitoring the operations of the largest bank in the U.S.  Either those regulators did not know of the hedge or did not understand the risks involved.  The trades were initiated in London so it might be feasible that the regulators did not know of the trades – except that both Bloomberg and the Wall St. Journal had called attention to the risky trades in April and Jamie Dimon had dismissed any concerns about the risks.  This example should refute the arguments of those who champion ever more regulation and more regulators of all business activity as the solution to keep the public safe.  The housing, securities, banking and insurance industries are all heavily regulated yet the confluence of poor risk management in these industries led to the debacle of 2008.  Regulations too often morph into a job programs for regulators and lawyers without achieving the desired goal of protecting the public from grievous harm.

The voters elect representatives to go to Washington to write competent laws.  Instead, the voters get poorly written laws written by a mish-mosh of inexperienced lawyers, industry lobbyists and passionate but impractical partisans.

JPMorgan gives the impression that Bruno Iksil, the London trader responsible for these aggressive trades, was a rogue trader  –  that the bank’s risk management team should have supervised him more closely.  What JPMorgan doesn’t readily disclose is that Mr. Iksil made the bank almost a half billion in profit just six months ago using equally aggressive trades.  Why supervise someone who apparently has the golden touch?

Where does JPMorgan get the money to engage in this risky gambling?  Your money.  JPMorgan had about $1.3 trillion in deposits from small depositors and large customers on its books but only about $700 billion in loans, leaving it with a lot of extra money, insured by the taxpayer, to gamble with.  They lost.  For now, the stockholders are the ones who have paid the price.  The stock has lost 24% of its value since the trading loss was confirmed by Jaime Dimon.  The amount of money lost so far is less than 1% of JPMorgan’s assets.  But it raises the question raised so alarmingly just a few years ago:  WTF????!!!  When I put my money in a bank, I expect them to keep it safe.  I don’t want the bank to take my money and gamble it.

Banking Reform

Stayed up way too late watching the Senate banking committee debate resolutions to correlate the language of the House and Senate banking bills.  Finally went to bed at 1:30 AM MDT, and they were still going at it in Washington, where it was 3:30 AM.  Although pundits like to describe political conflict as a disagreement along party lines, there are other subtler alliances that cross party lines.  Democratic members of the 12 person Senate conference who were on the Banking Committee would align with banking members of the Republican Party on an amendment vote, while Democratic members on the Agricultural (Ag) Committee would align with a ranking member of the Ag who was a Republican, thus creating a difference in approach between Banking members and Ag members, regardless of party.

CNN money has a good summary of the reform bill that will probably go before the full House and Senate before July 4th.   Although proprietary derivatives trading restrictions on Wall Street firms was included in the bill, a 3% provision was included in the language, allowing these firms to trade derivatives as long as it does not exceed 3% of their capital, which most firms except for Goldman Sachs will not exceed.

What surprised me is the lucidity of members of the Senate at that time in the early morning, having spent 18 hours debating various language and amendments.  To pull an “all-nighter” at 20 years old is one thing – many of these Senators are in their fifties, sixties and seventies.  Very impressive.  What befuddles an ordinary person like myself is why, after 18 months of wrangling over the development of the bills’ language, does it have to come down to an endurance test?  The lawmaking process in a democratic republic is messy, almost as ugly as open abdominal surgery – and many of these lawmakers probably felt like MASH surgeons this morning as the sun came up.

Bank Tax

The Obama administration is proposing a tax on the largest banks, based on the amount of leverage they employ. The estimated annual amount of the tax is $10 billion a year. Goldman Sachs estimates that the largest banks made $250 billion last year before taxes and loan-loss provisions. Based on those numbers, the tax amounts to a manageable 2/10th of 1 percent.

Some banks have protested. The 2008 TARP law did require the White House to come up with some system to pay for any losses under the program but a government estimate of $120 billion in losses consists largely of losses in the automotive industry. Jamie Dimon, the CEO of J.P.Morgan says that banks shouldn’t have to pay for another industry’s losses.

That does seem unfair but Dimon overlooks the long term liability of credit default swaps that the government has assumed in the AIG bailout. The Depository Trust and Clearing Corporation estimates the net value of these swaps at $82B. Also overlooked is the full price that AIG paid banks like Goldman Sachs and Societe General on credit default swaps (CDS) totalling $62.1B. In the late part of 2008, many of these swap contracts were selling for as little as 25 cents on the dollar. Let’s conservatively estimate that AIG paid these banks $30B above market price.

Additionally, the Federal Reserve bought $1.45T in Fannie Mae and Freddie Mac mortgage bonds, paying full price for bonds that had fallen 30 – 40% in value. Among these investors were the large investment banks, who took the money from the Fed and re-invested it in Treasury bonds. I have not been able to find estimates of this gift from the U.S. taxpayer but it must be at least $100B for the larger banks as a whole.

In short, the banks will be repaying taxpayers far less than they will have received from taxpayers.