The Balance Sheet Future

Why Banks Want to Return TARP Funds

The Government's financial system bailout/rescue plan focuses on the lack of lending to consumers and businesses as  banks in the country preserve cash to repair their balance sheets.  The TARP's Capital Assistance Program designed under former Treasury Secretary Hank Paulson provided (and perhaps forced) capital to banks of all sizes, beginning with eight institutions in late October 2008.  Recently, JPMorgan, Goldman Sachs, Bank of America and other TARP recipients expressed their intention to promptly return the taxpayer capital and remove government influence and scrutiny over their businesses.  If these institutions are drowning in loan losses and desperately need capital to improve their balance sheets how can they afford to repay the TARP money?

A review of last week's updated FDIC Quarterly Banking Profile (QBP) for the fourth quarter of 2008 provides several reasons why the banks can afford to repay the TARP capital.  Despite posting an industry-wide quarterly loss of $32.1 billion and continued deterioration in asset qualify, the industry's cash flow position improved during the crisis:

Total deposits increased by $307.9 billion (3.5 percent) in the fourth quarter, the largest percentage increase in a quarter in ten years.  Banks' balances at Federal Reserve Banks increased by $342 billion in the quarter.  While 1,069 banks (out of 8,305) reported increases in reserve balances during the quarter, five banks accounted for more than half of the entire industry increase. 

So banks flush with cash due to the surge in deposits are parking the money at the Fed instead of making loans.  Got it, that explains the government's frustration with banks for not lending.  Wait a second, reading further into the QBP shows that most institutions actually increased their loans:

Three large banks accounted for all of the decline in the industry’s loans during the fourth quarter; most institutions grew their loan balances in the quarter. Almost two-thirds of all institutions (64.7 percent) reported increases in their loans and leases, while only about half as many institutions (2,865 institutions, or 34.5 percent of all reporters) had declines in their loan portfolios.

Most banks increased their loan portfolios?  Three large, over-leveraged banks restructured their loan portfolios while 64.7% of banks increased lending.  Banks simply do not need additional capital to meet demand for loans to qualified borrowers.  Furthermore, TARP capital costs banks 5% annually and comes with incredible intrusion into their business decisions.  With strong deposit growth most institutions have sufficient cash to meet their funding needs and it should come as no surprise that many want to return the TARP funds promptly.  Perhaps the Fed and Treasury, in the face of declining credit growth, have lost sight on the real reason for the lack of bank lending: a lack of demand by businesses and consumers.  No bailout or new Fed lending acronym will spur demand, only time will heal these wounds.

Note: Please do not take this post as an endorsement to invest in financial stocks as many significant risks remain.

 

Crazy Fed Day

The Federal Reserve's FOMC Statement today led to large rallies in treasuries, foreign currencies and the stock market.  Breaking down the statement in comparison to the previous Jan 28, 2009 statement shows the following:

- Target range for the federal funds rate remains at 0 to 1/4 percent and the wording regarding the duration of the low rates was unchanged at "an extended period of time."

- Inflation expectations were also unchanged with the FOMC expecting "inflation to remain subdued" and continuing to "see some risk that inflation could persist for a time below rates that best foster economic growth and price stability."

- The Committee's opinion on the economic recovery improved as they removed the following statement that appeared in January's statement from today's release, "the downside risks to that (economic) outlook are significant"

- Lastly, Bernanke & Co. pulled out the bazooka, helicopter, tank and all other monetary weapons of mass destruction with the statement about further increasing the Fed's balance sheet.  The FOMC committed to purchase an additional $750 billion of agency mortgage-backed securities as well as an additional $100 billion agency debt and the big market mover of $300 billion of longer-term treasury securities over the next six months.

Today's announcement saw massive intraday reversals in the price of gold ($50+) and in the ten and thirty year treasury bonds (up 4+ and 5+ handles, respectively).  The most interesting move is the large drop in the dollar index.  This daily chart shows the index breaking down after a two week slide:

FASB Unlikely to Suspend Mark to Market Rules

The debate over mark to market (or model) accounting and its role in the financial crisis made its way to Congress today.  The concern is that banks will not incur the losses booked per mark to market accounting as asset values recover over time from today’s clearance sale prices.

Last month the FASB initiated a project to improve guidance on determining fair value and on disclosure of fair value estimates.  The project was scheduled for the second quarter and includes determining when a market is active or inactive and applying fair value to hedge fund and private equity investments.  The project will now move forward sooner after House Panel gets FASB pledge on accounting rule.

A House panel wrung a pledge Thursday from the head of an accounting board to try to issue guidelines in three weeks that will ease rules that force banks to value assets at current prices.

The commitment by the chairman of the independent Financial Accounting Standards Board came amid a muscular display of congressional power at a hearing on the so-called mark-to-market accounting rules. The head of the House panel, Rep. Paul Kanjorski, D-Pa., had held out the threat of legislation to pressure the standard-setting board and the Securities and Exchange Commission to take steps that would give relief to battered banks.

Congressman Kanjorski’s threat of legislation should remain just a threat, as the free markets of the United States do not need politicians determining accounting standards.

"We may help save the jobs of several million Americans and help keep the country out of a worse economic situation" than the current one, Kanjorski said.

Moving accounting numbers around will not lead to consumer spending, job creation and growth.  It will serve to give financial companies a breather and time to recapitalize.

I agree that to mark the value of all the houses on a street to the price of the one foreclosed home is inappropriate.  On the way up these same companies (and their stocks) benefited from increasing asset values but now that the financial industry is at the edge of the cliff, these same rules look to strict.

The FASB Chairman did not put suspending mark to market accounting on the table.  In fact, Chairman Herz had this to say in his testimony:

We agree with the SEC’s conclusion that fair value did not cause banks to fail. Rather, its use can help to more promptly reveal underlying problems at financial institutions. We also agree with the SEC that suspending or eliminating the existing fair value requirements would not be advisable, would diminish the quality and transparency of reporting, and could adversely affect investors’ confidence in the markets.

Of course, good accounting and reporting can have economic consequences, including potentially leading to what some term as procyclical behavior. Highlighting and exposing the deteriorating financial condition of a financial institution can result in investors deciding to sell their stock in the entity and lenders refusing to lend to it, to the company trying to shed problem assets, and to regulators and the capital markets recognizing that the institution may be in danger of failing and need additional capital.

I believe these (procyclical behavior) concerns are more effectively and appropriately addressed through regulatory mechanisms and via fiscal and monetary policy, than by trying to suppress or alter the financial information reported to investors and the capital markets.

The last thing the market needs is less transparency and more difficulty understanding financial institution’s balance sheets. The FASB, under tremendous pressure from Congress and Wall Street, will likely relax the rules by providing better guidance allowing companies to rely on their models more but require additional detailed disclosure.  I hope Chairman Herz and the other FASB members find a good medium for fair value accounting that gives banks time to recapitalize and investor more detail about an institution’s holdings.

A Bank Plan: Get Back to Banking

The U.S. banking industry will be recapitalized in the next six months.  Whether through private capital or taxpayer money, the banking system will move on from its darkest hour.  In fact, old-fashioned banking has never been better. Total deposits at FDIC insured institutions grew by $307.9 billion or 3.5% during the fourth quarter of 2008, the largest percentage increase in ten years.  The increase in deposits comes when deposit spreads are widening as the interest rate paid to depositors dropped with the Fed’s rate cuts of the past two years.  The Fed wants banks to be profitable so they can internally generate capital to fill holes created by losses.

 

Once the deleveraging process is over smaller and mid-size banks with clean balance sheets and a renewed focus on offering traditional financial products to their business and consumer customers will be profitable.  The question is what will become of the largest banks; Citigroup, Bank of America, JP Morgan Chase, Goldman Sachs and other commercial institutions that have segments focused on “risk-prone capital market activities.”  Last week in his Testimony to the Joint Economic Committee, Paul Volcker discusses removing the “capital market activities” from the institutions that focus on “relationship oriented” financial services:

 

"Taken together these banking organizations (large systemic organizations) should be predominantly “relationship-oriented”, providing essential financial services to individuals, businesses of all sizes, and governments. To help assure their stability and continuity and limit potential conflicts of interest, strong restrictions on risk-prone capital market activities e.g. hedge funds, equity funds, and proprietary trading would be enforced.

At the same time, trading and transaction-oriented financial institutions operating primarily in capital markets could be less intensively regulated, although stronger registration and reporting requirements would be appropriate. In instances where the institutions are so large or otherwise so complex as to be “systemically” relevant, capital, leveraging and liquidity requirements would be imposed.”

 

Volcker’s idea of a banking system that provides for risk taking with truly private capital, not capital that is backstopped by the taxpayer, makes sense.  The current financial crisis clearly shows the problem of leveraged risk-taking; a business that public capital (through commercial bank deposits) should not be near.

 

The administration and Federal Reserve remain focused on recapitalization and trouble asset problems and will later address a new framework for the financial industry.  In his testimony to the Senate Budget Committee Chairman Bernanke asked congress to focus on restoring stability and away from long-term effects:

 

"Policymakers must remain prepared to take the actions necessary in the near term to restore stability to the financial system and to put the economy on a sustainable path to recovery. But the near-term imperative of achieving economic recovery and the longer-run desire to achieve programmatic objectives should not be allowed to hinder timely consideration of the steps needed to address fiscal imbalances."

 

I hope the administration considers Mr. Volcker’s thoughts as it finalizes the bank bailout/recapitalization plan.  The administration’s current course of action focused around additional capital to cover losses does nothing to solve the deep-rooted problems of the financial system.  During restructurings business segments not core to the institution’s objectives are divested or wound-down.  I hope that as the financial industry restructures, leveraged risk taking is left to private capital and the taxpayer with their bank deposits better protected against future losses and bailouts.

Unemployment is Here to Stay

Today's employment report showed an additional 651,000 jobs lost in January and an unemployment rate of 8.1%.  With unemployment now above 8%, let's take a look back at the historical data since WWII:

Seasonally Adjusted Unemployment Rate (%)

As the chart just catches on the left, the current unemployment rate of 8.1% is still below the peak level of 9.0% in 1975 and the 10.8% level in 1982/3.  Looking over the monthly data from the last four unemployment rate spikes show that we are just getting started with these high unemployment levels.

1974 - 1977: unemployment jumped to 7.2% at the end of '74 before peaking at 9.0% in May '75.  Unemployment remained above 8.0% for all of 1975 and above 7.0% for 31 consecutive months.

1980-1985: the unemployment rate broke 8.0% in November '81, 9.0% in March '82, 10.0% in September '82 and peaked at 10.8% in December '82.  The rate remained above 10.0% for 10 consecutive months and above 8.0% for 27 straight months.

1991-1993: unemployment rose to 7.0% in October '91, topped out at 7.8% in June '92, then remained at or above 7.0% for the next 12 months.  Overall the rate spent 21 straight months above 7.0%

2002-2003: unemployment peaked at only 6.3% in June '03 and was above 6.0% for seven consecutive months.

During the 70's, 80's and 90's the labor force experienced periods of prolonged high unemployment rates.  During the short recession on 2002-2003 unemployment became elevated but did not spike to the above 7.5% levels likely needed to wash out the excesses of the tech boom.  How did the economy avoid the large layoffs?  The Federal Reserve Bank responded to lower their fed funds target rate to 1.0%.

The Fed dropped rates to 1.0% and kept them there for 12 straight months.  Additionally, they kept the rate at or below 2.0% for more than three straight years!  This decision by the Fed created the environment necessary to incubate the excesses of 2004-2007 where investors worldwide searched for higher return while ignoring risk.  Had the Fed not artificially set interest rates so low, many asset prices would not have gone to such extremes.  Unfortunately, as the right side of the chart shows, the Fed has again dropped rates down, this time to 0% to spur economic growth.  Had the Fed not dropped rates to the 1.0% level for twelve months in 2002/2003 the economy may have cooled off  sufficiently and we may not have the disaster we now find ourselves in. 

Looking back at the historical unemployment data shows that the 8.1% level reached in February may only be a milestone towards 10.0%.  During this downturn we should expect to see unemployment remain at high levels for many months or longer, similar to the experiences of the 1970's and 1980's.

Sources:
Unemployment date data via BLS
Fed Funds historical data via Money Cafe

Why Does Insolvency Not Equal Bankruptcy?

Another terrible day for financial stocks with the sector down more than 9%.  Even the institutions once considered stronger by some; JPMorgan, Wells Fargo and US Bancorp led the sector lower with declines of 14%, 16% and 18%, respectively.  Citigroup's shares fell below the $1 mark before closing at $1.02.  The market has voted and considers Citi (in terms of its common stock) insolvent.  For some reason the government feels that with more taxpayer money and time the company's solvency problem will resolve itself.  For the Government, insolvency does not equal bankruptcy.

Bernanke Says U.S. May Need to Expand Bank Rescue

Federal Reserve Chairman Ben S. Bernanke said policy makers may need to expand aid to the banking system beyond the $700 billion already approved and take other aggressive measures even at the cost of soaring fiscal deficits.

“Without a reasonable degree of financial stability, a sustainable recovery will not occur,” the Fed chairman said today in testimony prepared for the Senate Budget Committee. “Although progress has been made on the financial front since last fall, more needs to be done.”

Financial stability occurs when assets trade from weak hands to strong hands.  The government's solution to expand aid bailout funds to the financial system is delaying the recovery.  The Fed and Treasury cannot guarantee or buy every asset in the US financial system.  Losses must be realized and weak institutions let fail so the strong can survive and eventually grow.

The government instead focuses on the lack of lending by institutions to businesses and consumers.  Businesses and consumers are not borrowing because they do not need to borrow more money.  Businesses are cutting expenses and focusing on cash flow.  Consumers, who overspent coming into the downturn, are tapped out and now focus on saving.

Promote Recapitalization

The massive asset price bubble that took place due to freely available credit and leverage has burst . We will not see the previous price levels for decades.  Asset owners throughout the world must recapitalize based on new prices and leverage ratios.  This recapitalization will result in additional losses in the banks, commercial real estate and insurance companies. Those institutions without the cash needed to recapitalize will sell assets to the institutions with stronger balance sheets and the system will be strong again.

How the Bush and Obama administrations missed this point is beyond me.  The government should not give bailout money to institutions that need to plug holes on their balance sheets while they wait for asset prices to come back.  The answer is not a suspension of mark to market accounting.  Balance sheets must be reset with weak institutions left to market forces.  To achieve financial stability the government needs to promote recapitalization.

Automotive Depression

February's U.S. auto sales were at the lowest level since 1981 .  The Bailout 3's sales were down 49.3% from last year.  Consumers do not need a new car, they no longer feel the need to trade up every three years to a new car.

Automotive Depression

The results mark the 16th consecutive monthly drop in auto sales and come as a deepening recession in the United States and slowing global markets have pushed automakers to ratchet back production, ramp up discounts and seek government financing in a bid to survive.

"In our view, we are in an automotive depression," said Standard & Poor's equity analyst Efraim Levy.

"Shell-shocked consumers fearful for their jobs, the value of their homes and stock market assets are wary of making the sizable discretionary purchases," he said.

Consumers are trading down, finding value in Hyundai, Kia and Subaru whose sales were about flat from last year.  A change in consumer behavior is setting in as buyers are more price conscience and spending within their means. Consumers are focusing on their savings versus their spending. 

Flat is the New Up

Hyundai, South Korea’s largest automaker, said it sold 30,621 vehicles last month, down from 31,090 a year earlier. The company spent an average of $3,031 a vehicle last month, its highest level, according to Edmunds.com, a provider of auto- industry information based in Santa Monica, California.

Such spending was unchanged from January and is part of efforts to fight the market’s decline and build the brand’s image, said Dave Zuchowski, Hyundai’s U.S. sales vice president.

“In this market, we think flat is the new up,” he said in an interview. “If we’re flat again in March I’ll be happy.”

When will the auto manufacturers realized that we are not headed back to sales levels of 2004-2007?  They need to start drastic changes to their companies today.  Instead automakers across the globe are focused on government handouts.

Government Aid

Overall sales fell to 9.1 million vehicles on the annualized basis tracked by analysts, the lowest level on that basis since December 1981.

"These are obviously unsustainable levels and will cause almost every major automaker across the world to seek government aid," said GM's chief sales analyst Mike DiGiovanni.

Toyota, which passed GM as the world's largest automaker last year, said earlier it had applied for a Japanese government loan to help its finance arm cut funding costs.

Even the mighty Toyota is going to the trough for government assistance as their sales were down 39.8% from last year.  Governments need to let the auto manufacturers work through their problems privately, without taxpayer assistance.  By bailing out all the auto companies Governments are not allowing the weakest, least profitable manufacturers to fail, making way for the stronger companies to survive and thrive upon recovery. 

For more on the auto woe's, please see GM Loses $84.7M Per Day and Auto Bailout Task Force Takes Time.

Is Buffett Wrong on Treasuries?

In Berkshire Hathaway's 2008 Shareholder Letter, Warren Buffett makes mention of the US Treasury bond bubble of late 2008.  Mr. Buffett writes:

When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.

Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long. Holders of these instruments, of course, have felt increasingly comfortable – in fact, almost smug – in following this policy as financial turmoil has mounted. They regard their judgment confirmed when they hear commentators proclaim “cash is king,” even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.

Concern that demand for US Treasuries will dry-up are likely overdone as investors will continue to seek a return of principal rather than Mr. Buffett's return on principal argument.  Hyperinflation is not around the corner.  Let's review my prior post, Gold - No Liabilities Attached:

Inflation is not right around the corner.  Demand for all goods and services continues to decline and consumers across the country remain concerned, and rightly so, about the job market.  The monetary printing to come from the Obama administration's stimulus package and the bank and auto bailouts will not cause runaway inflation.  Credit is the key driver to inflation and both demand for and supply of credit are shrinking.  Until the growth of credit recovers hyperinflation concerns are overdone.

Is the drop in the 10 year treasury yield another bubble waiting to burst or do the low yields represent deflation and real interest rates near normal levels?  As fear retreats treasury investors will require higher yields but not in a bubble bursting manner as many are predicting.

The move into treasuries is not speculative, it represents the ongoing problems in the financial system, the eroding economy, and the lack of a real solution to the problem. Until the clear downtrend in yields since their peak in the early 1980's is broken US treasury bonds remain a place to preserve capital.