Category: Federal Reserve

Romer Regrets

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Jerry referred me to an article by Dana Milbank at the Washington Post, relating comments by the departing Christina Romer, Chairman of Obama’s Council of Economic Advisors.  According to Mr. Milbank, Ms. Romer said “she still doesn’t understand exactly why [the economic collapse] was so bad.”   Ms. Romer, well respected in her field, will probably share some of the blame for underestimating the deep structural weakness of an economy in which all the players had become over leveraged. In Ms. Romer’s defense, the cautious Federal Reserve, including the former chairman, Alan Greenspan, and the stock market underestimated the problem as well.  The Fed called for a recovery in the latter part of 2009.  The market’s rise from the March 2009 lows signalled the same outlook.  The stock and bond markets reflected the opinions of a majority of economists at investment houses, mutual funds, hedge funds.  How could so many educated people be wrong?

Ms. Romer is a proponent of Keynesian economics, a theory that government spending can offset the lack of demand in the private sector during recessions.  When John Maynard Keynes proposed his theory in 1930, his remedy of government spending was an antidote to smooth the regular ups and downs of business and economic cycles. In his theory, Keynes proposed that governments then run surpluses during good times to counteract the overly heated demand of the private sector.  As such, Keynes could not have imagined that governments would run up the large amounts of debt that they have in the past decades.  His theory was never designed for a recession or depression resulting from such a massive over-leveraging of both public and private debt.

Misjudging the scope and severity of the collapse of this asset and debt bubble led economists like Ms. Romer to think that Keynesian solutions like the stimulus bill passed in early 2009 would provide a substantial “kick” to the economy.  The stimulus bill has helped stopped the bleeding but the wound is deep.  Government tax credits for house and car purchases did little more than shift those purchases forward in time. Stimulus payments to states helped avoid state and local government employee layoffs – for a while.  They did nothing to fix the central problem:  businesses and consumers are paying down debt that they have spent almost a decade accumulating.  That de-leveraging is going to take time.

Economists who have a more classical view of the mechanics of commerce predicted that we might tip into a double dip recession, at worst, or a very slow “U” shaped recovery starting in 2010.  As a number of economic indicators turned positive in the early part of 2010, these same economists thought they might be wrong.  Some Keynesians felt vindicated as this economic data seemed to show that their model of government spending could shorten even a severe recession.

In February,  government deficits in Greece and several other European nations revealed the structural weakness of their economies and caused the stock and bond markets to question whether these smaller economies could withstand the relatively high ratio of government spending and debt as a percentage of each country’s GDP.  Germany, a paradigm of conservative fiscal policy, was forced to step in to help support these less fiscally responsible nations.  The European Central Bank, supported by the Federal Reserve, professed a firm support for the bonds of these weaker European nations.  With the magic that only central banks possess, the Federal Reserve pumped $1.2 trillion into U.S. government backed mortgage securities, signalling that it would not allow the newly recovering economy to fall back. In the spring of 2010, the market once again turned to the recovering economy.

Employment usually lags in any recovery and so many expected the unemployment rate to stay high going into the early part of 2010.  In April, after 8 or 9 months of expansion in the manufacturing sector and a recovering service sector, economists were expecting at least some reduction in the unemployment rate.  By late June and early July there appeared to be little increase in hiring.  Those who believed in a more traditional “V” shaped recovery began to have doubts and the market dropped to reflect these lowering expectations.

Week after week come conflicting economic reports, the Federal Reserve is running out of tools other than the rampant printing of money and the unemployment rate stubbornly hangs from the cliff of 10%.  Classical economic models seem to more accurately reflect the slow, tortuous climb out of the debt pit.

Decades from now, regardless of what happens, Keynesian economists will still profess that Keynes’ economic model was right – with perhaps a few modifications to their theory.  Classical economists who agree with the models of Hayek and Friedman will maintain that they are right – with a few modifications.  Fifty or a hundred years from now, our kids’ grandkids will get to do it all over again because too many policymakers would rather cling to their theories than learn from experience.

The Big Picture

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Or maybe the title of this post should be “The Big Pitcher”.  No, it’s not about a tall baseball pitcher, but the glass pitchers that central banks around the world hold.  What comes out of the pitcher when the central banks start pouring?  Money.  How do they do that?  It’s magic.  Don’t you wish you had a money pitcher?

Jerry forwarded me an article by someone at Matterhorn Asset Management, a Swiss asset management company that invests primarily in metals as a wealth preservation model so they will have a predisposition to a gloomy outlook because investors’ fears will bring more business to the company.  That said, the article presents a 200 year review and outlook on the mechanics of inflation and rather dire long term predictions for the world economy.

Featuring a 150 year chart on the Consumer Price Index and another one of US Debt to GDP ratio, this 6 page article definitely takes a long view of events in the past in making prognostications of the future. 

A comparison of the 19th and early 20th century with the latter part of the 20th century has to be put in a bit more perspective than this article does.  Electricity is something we take for granted but its effect on our lives has been as profound as the discovery of fire and the invention of cooking.  It is an energy that is readily available to most people in developed countries.  This ready source of energy has radically transformed our society, our productive capacity and our demand for products that use this energy.

In the 1920s, the new industry of radio telecommunications kicked off a bubble in the stock market.  Some predicted that we would walk around with communication devices that we wore on our wrists.  Information would be readily available to all with these cheap and portable two way radios.  It would be another 70 years before this dream would become a reality with the internet and the dawning of the cell phone age.  That in turn prompted another stock bubble in the late nineties.

When countries around the world abandoned the gold standard in the past century, they did so because the supply of gold could not keep up with the rapid expansion of production and demand that accompanied the energy and communication age.  How profound has this expansion been?  Several historians have noted that a person living in Boston in 1780 would have felt familiar with most of what surrounded him in that same city in 1900.  Jump ahead another 50 years to 1950 and that same person would be totally disoriented in a city with electricity, flashing lights, automobiles, subways, TVs, radios and the sheer growth in the population of the city.

The gold standard simply could not accommodate this rapid expansion of economic activity.  However, the gold standard put brakes on the centuries old tendency of sovereign countries to print money or debase the currency.  After abandoning the automatic regulatory mechanism of the gold standard, we have found nothing comparable to provide some restraint on central bankers other than a trust in the wisdom and foresight of those like Ben Bernanke, Chairman of the Federal Reserve.  An entire world of billions of people depends on the wisdom of several hundred individuals making decisions at central banks around the world.  It is a daunting and vulnerable position we find ourselves in.

Federal Reserve for Kids

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Eight times a year, the Federal Reserve Bank publishes its Beige Book, a summary of economic conditions around the country. The Federal Reserve branch at St. Louis publishes a lot of current and historical information on the economy for adults but they also provide some educational tools for grade schoolers.

Our grandchildren will look back on these years as the “old days” and this past decade has had some memorable events – an election decided by the Supreme Court, 9/11, two wars, Katrina, the banking meltdown, the oil spill.  The St. Louis Fed features a timeline of banking, credit and policy events for the past three years.  You can also download a PDF of the timeline so that, 10 years from now, you’ll have notes when you tell your stories.  The grandkids will think you know everything.

Easy Money

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A Future of Finance article in a December 2009 Financial Times quoted a partner at a leading London law firm: “There are huge piles of toxic debt on these [bank] balance sheets but much of it isn’t being recognized. Loans are being rolled over. There is a saying in banking circles now that ‘a rolling loan gathers no loss'” The same article also quoted Raymond Baer, chairman of Swiss private bank Julius Baer, who warned: “The world is creating the final big bubble. In five years’ time, we will pay the true price of this crisis.”

In a WSJ op-ed 10/16/09, Ann Lee, a former investment banker and hedge fund partner, writes that banks are hoping that by rolling over the loans at negotiated terms borrowers will eventually be able to make payments. She predicts that this cycle of rolling debt, reminiscent of what happened in Japan during the 1990s, could continue for a decade. With so much unrecognized bad debt, banks have little incentive to increase their lending. Instead, they borrow from the Federal Reserve at near zero interest rates and use the money to buy Treasury bonds, pocketing the difference in interest rates as profit. Since Treasury bonds are taxpayer IOUs, taxpayers are effectively subsidizing the profits of Wall Street banks. Ben Bernanke, head of the Federal Reserve and chief architect of this subsidy scheme, was recently reappointed by President Obama.

In late November, Standard & Poors released their analysis ranking of 45 leading banks in the world, using a new risk adjusted capital ratio (RAC), which will probably be adopted in 2010. This ratio gauges a bank’s leverage of assets to equity with greater attention paid to the risks of those assets than the current Tier 1 capital ratio does. According to this more rigorous metric, banks like Japan’s Mizuho and Sumitomo Mitsui, Citigroup, and Switzerland’s UBS have a particularly weak capital base. Just nine of the 45 banks rated by S&P had an adequate risk adjusted capital.

Business Outlook Survey

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Each month for the past forty years, the Federal Reserve conducts a survey of businesses, attempting to ascertain both current conditions and future anticipations of orders, costs, inventory levels, and employment. December’s survey shows continued improvement in current activity but there is a disturbing decrease of confidence in the future in those businesses surveyed.

In 2010, the businesses surveyed are expecting their costs to increase about 8% in two areas: energy and health care for employees. They project only moderate increases of about 2% in other costs. Only 12% anticipate lowering prices, while 12% project higher prices.
Welcome to the “New Normal”.

Consumer Debt

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Each quarter, the Federal Reserve calculates the average percentage of debt payments to income for households in the U.S. In 1980, credit card and automobile lease payments were about 11% of disposable, or after tax, income. By 1998, they had climbed to 12%. In 2006, that percentage broke 14%. During 2008, the American consumer has been whittling down that percentage to about 13.5% of disposable income.

Every 3 years, the Fed conducts a detailed survey of consumer finances. In its most recent released 2007 Survey of Consumer Finances, the Fed found that 2/3 of families had applied for credit in the past five years. 30% of those had been either turned down or been approved for less credit than they applied for (pg 45). 73% of families had credit cards but only 60% of those with credit cards had balances due, a healthy sign that families were paying off their credit card balances each month (pg 46). However, those holding credit card balances saw a 25% increase in their balance to about $3000. The median interest rate on a bank type credit card was 12.3% (pg 47).

Einstein said that compound interest was the most powerful force in the universe. When we owe debt, that power of compound interest is working for the other guy, the company we owe the money to. That 12% in interest we pay to a credit card company is in after tax dollars, meaning that it is more like 15% – 20%, depending on the tax bracket we are in. Translating that into hours, it means that we may work 1/2 day to a day each week just to pay the interest on the debt. We become someone else’s work slave.

Debt Burden

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In his book “American Theocracy”, economist Kevin Phillips compares this decade with that of the Depression. In 1929, the total of government, corporate, financial and household debt was 287% of GDP. In 2004, it was 304% of GDP. At the end of the first quarter of 2009, the Federal Reserve estimates that we had almost $34T in debt. With an estimated annual GDP of $14T, we have a debt load about 2.5 times GDP. That sounds better, huh? Not quite.

In 1929, there was no Social Security trust fund for the federal government to borrow from because Social Security would not be set up for another four years. Because Social Security pay outs have been less than Social Security receipts in the past several decades, largely due to the large number of working payers in the boomer generation, the Federal government has been borrowing this extra money. By borrowing from the Social Security trust fund, the federal government does not have to borrow from other countries like China, but the easy availability of this money has allowed politicians on both sides of the political aisle to fund a lot of programs through the years by borrowing against the future – our future and our children’s future.

The Federal Reserve does not include this “intergovernmental” debt in its calculation of total debt, estimated at $4.3 trillion. Add that to the total debt load of $34T and the total comes to more than $38T of debt or a percentage of total debt to GDP that is close to that of the depression.

The good news is that Americans have been reducing their debt load. The bad news is that we still have some ways to go to get healthy. It will be a slow recovery as reduced consumption continues to dampen production.

Bank Stress Tests

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After stressing all of us out, the 19 largest banks had to undergo a stress test of their own. On 5/7/09, the Federal Reserve (Fed) released the results of their several month stress tests on the 19 largest banks in the country. These tests project certain levels of unemployment, loan delinquency, falling asset values and determine whether banks have the capital cushion to withstand the losses.

The stress test used a 9.5% unemployment rate, which some felt was too low. Weekly unemployment figures released 5/8/09 showed an 8.9% rate and it is widely believed that the rate will go over 10%. The U6 unemployment rate, which includes people who have given up looking for a job and those who have taken part time employment because they couldn’t find full time work, is estimated by the Fed at 15.6%. This figure is a more accurate indicator of the true impact of unemployment on the work force and the economy.

In April the Fed released their preliminary stress test results to the affected banks. Some bank executives were furious, claiming that the Fed was being too severe. The final figures released this past Thursday were the negotiated figures.

The capital deficit of Citigroup was originally estimated at $35B. The revised figure was $5B. Heck of a negotiation there.

In a front page WSJ article 5/9/09, an analyst calculated that the capital shortage of the 19 banks would have been $143B if the Fed’s revised results had accounted for unrealized losses. Those revised results required that the banks add only $75B to the capital on their balance sheets to protect themselves against future losses over the next two years.

As long as unemployment doesn’t get too much worse and real estate prices don’t decline much more, the banks should be in adequate shape.

These financial stress tests has been like the treadmill test that a patient undergoes to test the health of their heart. Perhaps we should take an example from the banks and negotiate with our doctors over the condition of the treadmill test. “According to your treadmill test, doc, I gotta lay off steaks and get more exercise. But you tested me while running. Now, how often do I run? Rarely. Your test is unrealistic. What if we did the test with walking fast instead of running?” Good luck with that.

Homeowner Equity

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In a 3/13/09 WSJ report by S. Mitra Kalita: the Federal Reserve announced that Americans had seen their net worth fall by $11 trillion, or 18%, in 2008. However, a historical perspective is still positive for those adults who have been building equity over the past two decades. “Not accounting for inflation, household wealth more than doubled from 1990 to 2000, and then, after a pause, rose nearly 50% before the bust of 2008.”

But many have not been building equity for two decades. Real estate, primarily their house, accounts for 35 – 40% of the total wealth of most households. Those who invested their house equity in a larger home, or who borrowed against that equity, have watched that equity disappear. The Fed reported that, at the end of 2008, homeowners collectively had only 43% equity in their homes, the lowest level since 1953.

In 1990, Americans had 14% of their wealth in stocks. By 2000, stocks comprised 33% of wealth, slightly more than Americans had in their homes. It was paper wealth. The collapse of the dot.com bubble and the recession after 9/11 “downsized” that stock wealth substantially. In July 2002, the average American retail investor had lost all the stock profits they had made during the 1990s.

The lesson: diversify. As stocks rise, take the money “off the table.” Stocks and houses do not rise in value indefinitely.

Mortgage Refinance

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It was a little after High Noon today in Colorado when CNBC interrupted their broadcast of House hearings on the $165 million AIG had paid out in bonuses. The voice sounded similar in quality to the one we hear when programs are interrupted for severe weather warnings. It was not a weather warning but an announcement from the monthly Federal Reserve meeting.

The Fed was keeping interest rates at 0%, as expected, but they announced that they intended to keep them there for the coming months. They announced a plan to increase their purchases of long term Treasury notes by $300B and extend another $750B to buy mortgages. That puts the total Fed commitment to mortgages at $1.25T.

Within 5 – 10 minutes after the announcement, both the stock market and Treasury notes shot up about 2%.

So what! It’s not as exciting as the video of Brittany Spears practicing her dance routine for her upcoming tour. It’s not as fantabulous as a preview of the upcoming Jonas Brothers concert movie. It’s well, adult exciting. No, not that kind of adult excitement, you perv. The other kind of exciting, the green kind.

Now is the time for mortgage holders to start talking to a mortgage lender near you about refinancing. Average 30 year fixed mortgage rates were just a scosh below 5%. The Fed’s announcement will probably cause the mortgage rate to drop to 4.5% or so.

A fairly close approximation of the monthly principal and interest payment (PI) on a 30 year fixed mortgage at 4.5% is to chop off the last two zeroes on the amount of the loan, then divide by 2. For example, take a $200,000 amount, chop off the last two zeroes, which results in $2000. Divide by 2 and the PI comes to $1000. The actual amount, using a mortgage calculator , is $1013.37. Close enough for government work.

For anyone who might have an existing 6.5% mortgage rate, which was approximately the norm a year ago, the monthly payment reduction on a $165,000 balance is over $200 a month.

B.J. made a comment a few weeks ago that the government should just reset all mortgages, by fiat, to 4%. That is a sweeping government intrusion into the private marketplace, more extensive than the government has already done.

B.J. must have spoken to Ben Bernanke, the Fed chief, who agreed with her target interest rate. He just went about it without issuing an emperor’s decree. Instead of picking the cats up and taking them where he wanted them to go, Bernanke simply put the food down where he wants the cats to be.