Tim Duy's Fed Watch

Lowering the Bar

From the terms of the Capital Assistance Program:

As part of the application process, banks must submit a plan for how they intend to use this capital to preserve and strengthen their lending capacity – specifically, to increase lending above levels relative to what would have been possible without government support. The Treasury Department will make these plans public when the bank receives the capital under the CAP. (italics added.)

This is refreshing; unlike the initial TARP program, Treasury is not giving the impression that banks will increase lending - only that lending will contract by less than otherwise expected, all else equal.  Avoidance of a absolute collapse seems to be a reasonable goal.  I would prefer that we moved to avoidance of the Japanese scenario as well, but perhaps I just need to learn to be happy with small steps.

Of course, I can't see that it would be hard for the recipient bank to pick a safe baseline for lending in the absence of Treasury support (like zero).  Nor will it be easy to explain to the taxpayer that they should continue to expect lending to contract.  But at least we can say we were warned. 

Will TALF Do The Job?

The Administration is putting high hopes on TALF, especially now that the program will reach as high as $1 trillion (remember when $1 trillion was a lot of money?).  It has always seemed to me that TALF would fall short of the mark.  The key constraint:

Eligible collateral includes U.S. dollar-denominated cash ABS that are backed by auto loans, credit card loans, student loans, or small business loans that are fully guaranteed by the SBA, and that have a credit rating in the highest investment-grade rating category from two or more nationally recognized statistical rating agencies and do not have a credit rating below the highest investment grade rating category from a major rating agency.

The expansion of TALF to CBMS also requires AAA-ratings.  I suspected that limiting the program to investment grade securities would severely curtail the effectiveness of the program for one simple reason - that, relative to expectations of officials, investment grade borrowers are relatively few, and they have maintained that status by not accumulating excessive debt, so already they are not inclined to borrow.  The spending bubble was not driven by high grade debt; it was driven by low grade debt disguised as high grade debt.  Focusing on high grade debt as the solution will thus prove insufficient to give the economy much traction. 

Two recent stories tend to support this point.  First, from the Wall Street Journal:

The government's $200 billion program to revive the market for securities backed by consumer loans may end up providing little help to the very industry that needs it most: U.S. auto makers.

As the Federal Reserve hashes out final terms of its Term Asset-Backed Securities Loan Facility, or TALF, it is becoming clear that securities that help finance auto dealers mightn't meet some criteria. That would block a form of funding that auto companies had hoped would provide immediate relief as they fight for survival.

The problem came to a head because of credit ratings. The Fed has insisted that any deal it helps finance be given a triple-A rating from Moody's Investors Service, Standard & Poor's or Fitch Ratings. Bankers said this kicks out deals backed by loans to auto dealers because S&P and Moody's, in particular, have cut the ratings on such securities over the past several weeks as the industry grapples with potential bankruptcy filings and weaker demand for U.S. cars.

The second is from Bloomberg:

The Fed, through the TALF, could reduce the cost of financing commercial real estate by taking as collateral CMBS already traded in the secondary market rather just new bonds, said RBS analyst Lisa Pendergast in Greenwich, Connecticut.

Accepting bonds from the secondary market would be a “big deal” for reviving credit, said Jan Sternin, a senior vice president at the Mortgage Bankers Association in Washington.

The central bank also should make loans with at least a five-year term against CMBS, Pendergast said. The TALF is now geared to make loans of no more than three years against collateral, a misalignment with the typical five- or 10-year term of commercial mortgages.

“Nobody would buy a 10-year asset with a three-year loan,” she said.

The Fed initially proposed a one-year term for TALF loans it will make before revising to a three-year period in December.

Without TALF support, borrowers would have a tougher time refinancing maturing debt and avoiding delinquency or foreclosure, said Chip Rodgers, senior vice president at the Real Estate Roundtable, a trade group in Washington.

The Fed has said it will only accept newly issued AAA-rated CMBS collateral.  Presumably, newly issued CMBS could be used to refinance maturing debt, assuming the refinanced debt could be rated AAA.  And, I suspect, therein lies the heart of the industry's conundrum.  Given the deterioration in credit quality, we can presume that much of the maturing debt is rated at something less than AAA.  Much less.  Consequently, the TALF would do little to help refinance maturing commercial mortgage debt, at least directly (I would not count on the indirect effect of building confidence in dodgy assets via liquidity programs).  They know it - the article contains a telling quote:

Atlanta Fed President Dennis Lockhart said today that commercial real estate is “the one domestic factor that keeps me up at night.”

“Many banks are pretty heavily exposed to commercial real estate,” he said in Orlando, Florida.

Lockhart must sleep well compared to me; I have a laundry list of economic issues that keeps me up at night. 

If the maturing debt cannot be refinanced at reasonable interest rates, then rising defaults and additional asset markdowns will play further havoc on the banking industry.  The Fed cannot fix this if they limit their loan programs to AAA-rated ABS as the problem debt by definition has a lower rating.   This appears to be the signal the industry is sending, so holders of CBMS want the next best thing - the Fed to absorb the risk of the existing AAA-ABS:

Top-rated commercial mortgage bonds are currently trading at about 10.82 percentage points more than benchmark interest rates, compared with 2.32 percentage points a year ago, Bank of America Corp. data show. In January 2007, the debt traded at 0.22 percentage point.

Seems those "top-rated" bonds are riskier than expected.  Better to sell them off to the Fed (and eat the haircut) while they are still AAA rated.  Of course, it may already be too late; ratings are dropping fast:

Moody's Investors Services downgraded an additional $23.89 billion of commercial mortgage-backed securities amid concerns that losses would grow from increased leverage, reduced reserves to pay debt and loan losses.

The move follows the ratings firm's announcement last week that it would review the ratings of some $300 billion of bonds backed by commercial-real-estate loans. More than a quarter of those securities are vulnerable to multiple-notch credit downgrades.

Last Thursday, Moody's said it will apply new assumptions about falling property cash flows and stressed capitalization rates, which are the ratio of net income to its value, when considering the rating of the bonds. The review is slated to be completed within 60 days.

Including the latest round of downgrades, $62.09 billion of CMBS has been downgraded by Moody's the past week.

The commercial real-estate market had held up better than the residential real-estate market, but it began to deteriorate quickly at the end of 2008 as the recession deepened.

The ratings firm had expected cumulative losses of 2% on commercial bonds issued between 2006 and 2008, but it has increased that to 5%.

Moody's, which on Tuesday downgraded 124 classes and affirmed 69, expects a significant decline in future property cash flows on higher tenant defaults, bankruptcies and a sharp decline in lease-renewal rates. Those cut include 47 tranches valued at $6.6 billion from Wachovia Corp., which was acquired by Wells Fargo Co. five weeks ago, 11 classes valued at $3.8 billion at J.P. Morgan Chase & Co. and 10 classes valued at $2.8 billion at UBS AG.

Existing CMBS might not be rated AAA for long.

Bottom Line:  TALF limitations provide protection for the taxpayer, but curtail the program's effectiveness.  This is not meant to imply that efforts should not be made to support the normal functioning of credit markets; simply to keep expectations about effectiveness in check.

More Banks Behaving Badly

To be sure, banks, even those under financial pressure, need to pursue appropriate marketing and client development efforts if they expect to survive the crisis.  It is just part of doing business.  At the same time, firms under such intense public scrutiny should be cognizant of how such activities will be percieved.  At a minimum, scale them back from Gatsbyesque enterprises.  Apparently no one at Northern Trust got that memo.  For those of you without time to waste at tmz.com:

Northern Trust, a Chicago-based bank, sponsored the Northern Trust Open at the Riviera Country Club in L.A. We're told Northern Trust paid millions to sponsor the PGA event which ended Sunday, but what happened off the golf course is even more shocking.

Northern Trust flew hundreds of clients and employees to L.A. and put many of them up at some of the fanciest and priciest hotels in the city. We're told more than a hundred people were put up at the Beverly Wilshire in Bev Hills, and another hundred stayed at the Loews Santa Monica Beach Hotel. Still more stayed at the Ritz Carlton in Marina Del Rey and others at Casa Del Mar in Santa Monica.

- Wednesday, Northern Trust hosted a fancy dinner at the Ritz followed by a performance by the group Chicago.

- Thursday, Northern Trust rented a private hangar at the Santa Monica Airport for dinner, followed by a performance by Earth, Wind & Fire.

- Saturday, Northern Trust had the entire House of Blues in West Hollywood shut down for its private party. We got the menu -- guests dined on seared salmon and petite Angus filet. Dinner was followed by a performance by none other than Sheryl Crow.

There was also a fabulous cocktail party at the Loews. And how's this for a nice touch: Female guests at the Chicago concert all got trinkets from ... TIFFANY AND CO.

The expected Congressional response can be found here.

Not to worry; Northern Trust received only $1.6 billion in TARP money, but didn't ask for it.  It was just taxpayer money anyway - you know, little people.  They also laid off 450 people, but, again, little people, so also no worries.

More evidence that the US response to the financial crisis has degenerated into a sad joke.

Billions of Dollars Later...

Billions of dollars later, and consumer credit continues to contract...and now at least one firm is paying paying cardholders to drop their accounts.  From Bloomberg:

American Express Co., the largest U.S. credit-card company by purchases, is paying some cardholders $300 each to close accounts so the lender can reduce the risk of defaults as the recession deepens.

People who got the offer to “simplify” their finances must pay off their entire credit-card balance by April 30, according to New York-based American Express. Enrolling in the program cancels a customer’s account and may lead to forfeiture of reward points or rebates, the company said on its Web site.

“What AmEx is trying to do is move to the front of the line in terms of getting paid back” by customers who owe debts to multiple lenders, said Michael Taiano, an analyst at Sandler O’Neill & Partners with a “hold” rating on the company. “They clearly grew loans faster than their competitors in the years leading up to this financial crisis.”

American Express was a recipient of TARP funding, albeit a "nominal" $3.39 billion.  What makes this interesting is that not only is American Express not expanding lending - the selling point of the original TARP proposal - they are using the funds (money is fungible) to explicitly contract lending. Such a vivid illustration of the industry's challenges. And those challenges are only building. As the US government is goading investors with a line in the sand, consumer defaults are swelling:

Consumers are falling behind on credit-card payments as U.S. unemployment reached 7.6 percent last month, the highest rate since 1992.

This is just consumer debt; commerical debt pressures, including real estate, are building as well.  With the situation rapidly deteriorating, the anticipated stress tests look like a smoke screen to buy time in yet another emphemeral effort to restore the elusive confidence that policymakers hope will magically restore the system. 

Whatever news comes out of Washington regarding the plan of the day for the banking system, I hope one thing is soon made clear to the public - fixing the financial system is not the same thing as expanding lending.  We are way past that point; you can't fix the system with more bad loans.  If Treasury Secretary Geithner tries to sell his plans as the solution that will revive credit growth, I suspect he will further test the already strained credibility of the government.  A more honest approach:  We are simply trying to prevent the financial system from outright collapse. 

 

 

Divergent Unemployment Rates

It is common knowledge that educational achievement significantly impacts labor market outcomes.  Still, I was struck by the increase in that disparity as I prepared the following charts for a presentation last week.  Consider the year over year change in unemployment rates by educational achievement since 1993:

Note that the increase in unemployment rates for no high school and high school graduates are increasing at a very rapid rate over the past year (note this also reflects rising labor force participation for the no high school group (Jan. 2008 - Jan. 2009), in contrast to falling participation among other groups).  In contrast, during the 2001 recession, increases in unemployment rates were comparable.  For a closer look at 2001:

And the current recession:

A few thoughts come to mind:

1. Rising structural unemployment.  If the housing/consumer debt dynamic led us into this downturn, and, as I think is reasonable to expect, will not lead us out of the downturn, then we can expect that those persons unemployed as a result will continue to face relatively higher rates of unemployment in the future.  In essence, it is not clear to which sector these labor resources will be reallocated, especially given anticipated lethargic rates of labor growth on the other side of this recession.  I suspect that very strong growth will be required to revitalize a labor market for these individuals (such as that experienced during the information technology boom).  No such growth forecast exists.
2. Hysteresis?  That is a term that has not cross my mind for many years.  Suppose the economy is undergoing a structural adjustment that promises to deliver low growth rates for the next decade, with cycles driven by the start-stop process of fiscal stimulus.  Could each new "boom" end with an unemployment rate higher than the low of the previous boom as structural unemployment edges up? 
3. Stimulus may also have a differential impact on unemployment.  If the jobs generated by fiscal stimulus tend toward workers with higher education levels, then stimulus will not alleviate the problem of rising structural unemployment.  Note - this is NOT an argument against stimulus.  It highlights the importance of proper structure of the stimulus package.
4. Us versus them.  I hate to say this, but certain political partisans could turn this into a morality play...why should your tax dollars be wasted supporting the bottom end of the educational level?  They had their chance.  
5. Inflation risk?  If significant structural issues are in play, perhaps we are fooling ourselves about the low risk of inflation.  Consider Jim Hamilton:

I have in my research instead stressed technological frictions. For example, when spending on cars abruptly falls, there is a physical, technological challenge with getting the specialized labor and capital formerly employed in manufacturing cars into some alternative activity. In my mind, it is a mistake to pretend that any federal program is capable of immediately re-employing those resources into an alternative, equally productive enterprise. More fundamentally, I have suggested that our present situation is as if someone had quite successfully sabotaged the basic functionality of our financial system. Until we once again have a financial sector that can successfully allocate credit to worthy projects, we're not possibly going to be able to produce as much in the way or real goods and services, no matter what the level of aggregate demand or stimulus package might be. In terms of the textbook Keynesian models that people play with, I'm suggesting that "potential" GDP growth for 2009:Q1-- that growth rate which, if we try to exceed it by stimulating aggregate demand, we primarily just get more inflation-- is in fact a negative number.

I not ready to declare the end of deflation risks.  But I can easily make a story in which structural adjustment combined with misdirected stimulus yielded a higher than expected inflation rate.  As always, it is wise to consider the full range of risks to your outlook.

Bottom Line:  Yet another thing to worry about.

Waiting For Geithner

Treasury Secretary Timothy Geithner is slated to announce the latest financial stabilization plan Monday.  From various press reports and leaks, these are things to be looking for:

1. No bad bank.  The plan appears likely to leave toxic assets in the hands of the financial sector, rather than purging them from the system once and for all.  The bad bank idea is proving to be prohibitively costly if your fundamental goal is to maintain the status quo - one cannot shower the sector with such financial largess and expect to leave existing shareholders and bondholders unharmed.  Instead, there appears to be a move toward guaranteeing losses beyond a certain amount, a "ring fence" approach.

2.  More string tied to aid.  Institutions receiving aid will be subject to "limits" on executive pay, requirements that they modify troubled mortgages when possible, and requirements that government money stimulate new lending appear to be among the strings.  The additional strings will likely discourage willing participation.

3. Triage?  From Bloomberg:

The Treasury may increase its stake in lenders that are judged short of capital, the people said on condition of anonymity. Should extra taxpayer funds result in a majority ownership by the government, officials would then decide whether to liquidate the institutions, place them into receivership or retire the companies’ assets over time, they said.

This sounds like Treasury would try to identify those institutions worth saving, and either nationalize or liquidate those with that require federal help on the order of a de facto nationalization.  The Wall Street Journal suggests something different:

The rescue is shaping up to include a second round of capital injections with tougher terms. The government is looking to get money into banks by buying preferred shares that convert into common equity within seven years; that avoids diluting current shareholders' stakes while helping banks better withstand losses. The Treasury may also allow banks that already received capital injections to convert the Treasury's preferred shares to common stock over time.

The Journal version sounds like an effort will be made to protect existing shareholders and avoid nationalization. 

My suspicion is that Treasury will talk tough, but continue a band-aid approach that dribbles out funds at a rate that both avoids the messy issue of nationalization while providing insufficient funds for adequate capitalization, all while trying to keep toxic assets in the banking system.  Clearly, I am not optimistic.

4. Formal acceptance of agency debt.  This one circulated the markets Friday; explicit endorsement of agency debt should render it nearly as good as Treasuries, and bring yield spreads, and mortgages, down dramatically.  

5.  Foreclosure mitigation.  Reports suggest a stepped up effort for foreclosure mitigation to the tune of $100 - $200 billion.  I don't view this as an effort to prop up prices; it is simply not enough the weigh against the literally trillions of lost value.  I also suspect it is very difficult to identify homeowners who can benefit from reasonable modifications that don't require either a substantial and untenable taxpayer contribution or the homeowner becoming a virtual mortgage slave, tied to an unrealistic housing payment.

6.  Support for bankruptcy "cramdowns."

7.  A greater role for the FDIC. Give the FDIC authority to liquidate non-bank firms in an orderly fashion, and extend guarantees of financing bonds issued by banks.  The former would likely require legislation.

8.  Expanded role for the Fed.  The Wall Street Journal describes the evolution of the new TALF facility.  My favorite line:

Some hedge funds, which often use borrowed money to boost returns, are lining up to get in on the Fed program, seeing a chance to make high double-digit-percentage returns with little downside using low-cost loans made on easy terms. Some officials inside the Fed are nervous about relying on unregulated hedge funds. But they see it as a trade-off in order to get capital to consumers.

I can just see how this program evolved.  Fed and Treasury officials meet with Wall Street titans looking for methods to unglue the financial system.  The answer:  Create programs that guarantee risk-free double digit returns for wealthy investors.  In the meantime, I am trying to explain to aging Rotarians nearing retirement that they are simply screwed; the risk free rate for them and the other 99.9% of the population is pushing at zero. 

These appear to be the highlights; I hope I have not missed anything substantial.   We will soon see which leaks were accurate, and what details were not leaked. 

And Now We Know. . . .

I have been holding off on commenting about the impending, revised financial stabilization plan, content to let those such as Yves Smith express their dismay at the evolving package. I have run the gamut from dismay to anger to my current emotion, supreme disappointment. There were really only two glimmers of hope that the US could avoid a Japan-like multi-year stagnation. One was the offsetting effect of a strong global economy. Of course, we all know how that story ended. Poorly. The other was my certainty that US policymakers like NEC head Lawrence Summers and Treasury Secretary Timothy Geithner had studied the Japanese crisis up and down and realized that you needed to meet a banking crisis head-on, not with halfway measures that left the system crippled.

But today, reading CNBC’s coverage of the plan, it becomes painfully clear that we are headed full speed on a policy bullet train designed to repeat Japan’s errors. From CNBC:

The plan will be "smaller" than originally expected, said the industry source, and centered around government guarantees and insurance of troubled assets, what's called a "ring fence" concept.

Will the ring fence concept work? Consider this paragraph later in the article:

The ring fence concept has already been used with Citigroup ... and Bank of America... It involves government guarantees and insurance provisions for groups of bad assets, but they remain on the balance sheet of the institution. The bad bank concept literally removes them.

Look, just look, at the stock prices, plumbing the depths. From Bloomberg:

Bank of America Corp., the nation’s largest bank, declined to its lowest level in New York trading since 1984 on concern regulators may seize the company after a $138 billion U.S. bailout package failed to halt the slide.

I have got to say, at least from someone on the outside looking in, the US government appears to be headed down a path already proven to be a failure. Is more of a failing policy smart policy? But it gets worse:

The latest round of discussions also appear to have addressed the most controversial aspect of the big bank concept: Pricing.

Under the emerging plan, the government will buy toxic assets below the banks "carrying value," which is basically market value, but not at fire sale levels, the source said.

That approach will likely placate both taxpayer and Congressional concerns about the government over-paying for the assets. But, the source noted, it could "trigger an accounting problem for the banks," presumably because the institutions will have to report a loss on the transactions.

The Obama administration is now working on ideas to address that, which might entail a temporary suspension of certain accounting rules.

Classic. Absolutely classic. Is this really addressing the problem of pricing? Are we not in the same boat of “if we pay too little, the bank is undercapitalized, but if we pay too much, the taxpayer holds the bag and therefore we need to nationalize”? Obviously we are in the same boat, because the new plan may cause an “accounting problem.” Like insolvency. That is, in fact, a problem, no argument from me. Apparently, though, the Administration’s solution is a suspension of accounting rules. Translation – we are going to try to hide the problem.

As if investors won’t see through that mirage because all of you traders are clearly slow witted. Again, Bank of America already plumbing the depths…

Why are we here? Why, months after TARP, are we still not willing to dig down in the balance sheets of troubled banks and disgorge the questionable assets once and for all? Why, with a new Administration, supposedly unfettered from the ideological positions of the last Administration? More from CNBC:

The latest developments come as Congressional support for the bad bank concept and additional financial support for the financial sector is fading.

In a news conference Wednesday afternoon, House Speaker Nancy Pelosi (D.-Calif.) said she was "not so sure" that another bailout request from the Obama administration is inevitable, reversing an a previously-held assumption.

Sen. Charles Schumer (D-NY), a senior member of the Senate Banking Committee, Tuesday joined the bad-bank skeptics, telling CNBC the approach would be "hugely expensive" and added he prefers government guarantees of such assets.

Congressional Democrats, led by House Financial Services Committee Chairman Barney Frank (D.-Mass.)  have shared with the new administration their anger and disappointment over former Treasury Secretary Henry Paulson’s administration of the TARP program, which was seen as too generous to and too lenient on Wall Street firms.

The financial crisis has been so mismanaged that the public will not support package with a high price tag, a price tag that could climb into the trillions. And there is no way to even bring the issue to the public unless taxpayers effectively buy troubled banks, which can only be justified after first wiping out shareholders and bondholders. Then the bad assets could be rooted out once and for all. But this Administration appears no more willing than the last to consider temporary nationalization. They either do not want to own banks (I don’t blame them), or they are in too deep with Wall Street interests to upend the status quo.

We used to wonder aloud at the intransigence of Japanese policymakers. How could they allow their banking system to deteriorate? Why not take decisive action? Now we know: Fettered to an adherence to the status quo and an aversion to the concept of nationalization, the political will to attack the problem head-on is overwhelmed by the enormity of the financial crisis.

On a final note, the Administration still appears to selling the package with this line:

Both approaches are meant to spur new lending by banks.

And more from Bloomberg:

Earlier today, Senate Banking Committee Chairman Christopher Dodd urged the Obama administration to redesign the financial-rescue program to ensure that banks receiving aid increase lending and restrict salaries.

In the current environment, I can only imagine this is a pipe dream. The survey of loan officers shows clearly that while standards are tightening, loan demand is dropping off. Moreover, as the recession deepens and job losses mount, credit quality is deteriorating and loan losses increasing. Balance sheets are only coming under more pressure from rising credit card delinquency and expected downgrades of CMBS. Administration officials may find this hard to believe, but you cannot fix the banking system by encouraging banks to make more bad loans. And the number of opportunities to make good loans is rapidly drying up. If we sell this to the public – again – as the fix that will increase lending, there will be either massive disappointment or an effort to obfuscate balance sheets (since we are apparently ready to suspend accounting rules anyway) so that it appears government funds are being used for new lending (as if money was not fungible).

Geithner is slated to announce the new plan next Monday, February 9. Perhaps the final plan will be bolder than early reports suggest. And I can always hope that I am dead wrong and the “ring fence” concept is a spectacular success. But at this point, I am not optimistic...the Japan scenario is looming larger in my mind every day.