Monetary Policy: Monetary Policy Slamming on Breaks. What do you do when banks don’t want to lend? Become the consumer. Government getting ready to spend to stimulate the economy.
Monetary policy is a delicate game of cat and mouse. You raise rates, you lower rates, or you jawbone a little and normally, the markets respond to the Fed like a conditioned hamster looking for a piece of food. Yet the Fed has lost this power. What happens when the public gets a look behind the curtain and realizes there never was any sort of wizard? What happens is extreme market volatility unlike anything we have seen in nearly a century. Now maybe at this point with consumers closing up their wallets, not buying cars, putting away the American Express credit card, and finally deciding to exercise restraint, flooding the system with credit may be counterproductive.
First, let us look at life after TARP and how this has bailed out, I mean helped out banks:
*Click for sharper image
So what we see here is banks hoarding money from various sources including TARP. Yet banks are fearful because the psychology of excessive optimism has now turned to suspicious pessimism. Think for a couple of seconds. If you are bank XYZ you know 100 percent what you have on your books yet you are uncertain of what bank ABC has. ABC knows 100 percent what they have on their books. Yet the problem is, a large part of banking assets are now worth a lot less. Both banks know this. How much less is hard to determine yet you are fearful your buddy bank is holding on to the same toxic sludge as you are. This may not always be the case but that is what is occurring right now. In addition, banks are fearful about lending since they have been burnt so badly and are protecting their capital requirements. After all, some analyst expect one-third of the 8,300+ banks insured by the FDIC to fail by the time this crisis is over.
Things have gotten cheaper, at least in the short-term because of deflation yet how long this will last is unknown. First, a large part of this drag down is based on the oil bubble bursting:
The housing bubble popping was amazing yet looking at the oil bubble pop with such violent speed was also bad for the economy. We went from $147 a barrel to the low $30s in a few months. We’re talking a 79 percent drop! Real estate bubble? Credit bubble? Oil bubble? Commodities bubble? Equities bubble? Bond bubble? How many bubbles can we have!? Yet the oil drop might be short lived given the cut back in production now that many investors may find it pointless to search for new oil at lower prices. The futures market are already pricing in higher oil:
What the above chart tells us is the market sees oil rising steadily in 2009 to close to $60 a barrel. So if we take the low in the $30s to a $60 barrel price, we are talking about a 100 percent increase in one-year. Again, this kind of market volatility speaks more of a very unhealthy market.
So what does oil have to do with monetary policy? A lot. You need to consider oil as a commodity. Another form of money. In 2008 the U.S. dollar rose approximately 5 percent even after all the rate cuts and problems in our economy. This trend may not continue. As I have argued the U.S. Treasury and Federal Reserve would love to see nothing more than the implosion of the U.S. dollar. So when you have oil fall so drastically, this amounts to an immediate stimulus to many Americans in the billions per month. So even though banks aren’t lending per se, saving a few hundred each month serves as a mini stimulus. Yet this may be a small consolation given the extent of damage flowing through the system.
Also, what we see with the oil bubble bursting is how quickly things can change. When oil was at $147, the CPI was going haywire. In June, we had a 1.1 percent jump! So inflation was being talked about. Yet only a few months later in November, the rate came in at -1.7%! Now we are battling deflation. How can you go from worrying about inflation to deflation in 4 or 5 months? You can’t. The average American is feeling deflation; lower or stagnant wages, collapsing home prices, bursting oil, big rebates on cars, and cheaper retail items. Where is the inflation? It hasn’t been here for a long time.
Now this isn’t to say we won’t have inflation. Frankly, given the extraordinary irresponsibility of the Fed flooding the system with credit, I’m not sure how we avoid inflation down the line should that credit make its way into the mom and pop system. Given that historical measures show monetary policy having effects 6 to 18 months later, the TARP and all the other buying and exchanging of treasuries for questionable assets, I would imagine if we were to see any signs of inflation they would appear either in the 3rd or 4th quarter of 2009.
What is probably more disturbing is the velocity of money is slowing down and has been for this entire decade:
This is fascinating. We are looking at money of zero maturity MZM and also, M2 which is:
M2: M1 + savings deposits, time deposits less than $100,000 and money market deposit accounts for individuals. M2 represents money and close substitutes for money.
M2 is largely looked at to forecast for inflation. So here, it looks like things were all fine and inflation was totally under control. Well, using these measures it is understandable why Greenspan slashed rates in 2001. Yet recently the M3 component has been removed from the public data series (I wonder why); it is no longer measured when short-term repo methods were used to exchange junk for treasuries. Just look at the above chart showing bank reserves. Even though this number isn’t published we know where it is going. I’m no conspiracy person but my guess is this was done systematically to make it difficult for researchers to query any data in a timely fashion. Anyone reconstructing their own data would have to mark it “un-official” and we know how the mainstream media loves unofficial things.
Yet M2 and MZM have been steadily increasing:
So what is happening here? What is happening is money is freezing up in the system. It is no longer traveling as quickly as it once did. Even looking at these two measures, you are left scratching your head. Then what caused the bubble this decade? Credit mostly seen only in the M3 data set. If we would look here, we would virtually see a crashing velocity (heck, banks are hoarding money!) yet a large jump in terms of credit available. In reality, tons of credit is available in the system yet there isn’t enough credit worthy borrowers out there for the amount of available. We just lived through the biggest credit bubble in history and the solution is not more credit. That is ultimately what we are trying to do with this.
Monetary policy has run its course. That is why the next avenue to take is through fiscal stimulus. That is, the Fed and U.S. Treasury have spent all their ammo on banks and lenders yet none of this is making it to the micro economy. So now, the government is going to spend money it doesn’t have. To be fair, the money lent to banks (trillions) was money we didn’t have either. That is why this deflation is more of a shock treatment down yet long-term, we are going through the historical motions that will cause inflation eventually. That is, if history repeats itself.
Keep in mind that the destruction of the U.S. dollar will cause inflation. Oil will cost more. If you travel you certainly will feel it. Exports will all rise. That is, if other currencies don’t implode as well. We are all in a race to a zero interest rate world. We have very few historical measures for what is happening right now since we have so many bubbles bursting, credit flooding the system, a debtor nation who has the reserve currency, and other unique circumstances.
In the end, money has to reflect some intrinsic form of value. The notion of simply printing money out of thin air is by default inflationary. If printing money wasn’t problematic, why don’t we all have individualized printers in our house printing money 24/7? Yet money is simply a medium of exchange. This entire decade money exploded if we measured growth in M3, mortgage equity withdrawals, credit card debt, and other loans. People made the fatal mistake of confusing debt with money.
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With all the problems occurring in the banking system, it is rather astonishing that so few have failed in 2008. At least that is the perception being put out there for us to digest. Yet the failure of one IndyMac or Washington Mutual is the equivalent of 100 smaller bank failures all at once.
It is true that the composition of bank assets is primarily locked up in mortgages. Yet the true bank failures will be hitting in 2009 with the bust of the commercial real estate market. In this article, we are going to examine the makeup and anatomy of our banking system with data and charts from the FDIC.
Exhibit #1 – Composition of Bank Assets
The above chart should first tell you why the banking system has collapsed with the housing market. Banks rely heavily on mortgages for their asset base. With the housing market collapsing, it isn’t hard to understand why problems rippled through the core of many bank balance sheets. In addition, another large part of the composition of bank assets are secured via credit cards. Bankruptcies are skyrocketing and many people are now relying on credit cards as a last measure. A country with $49 trillion in debt is one that isn’t afraid to take out a loan.
Exhibit #2 – Number of savings institutions and commercial banks
At last count, there are 8,384 savings institutions and commercial banks backed by the FDIC. The FDIC recently upped its insurance for individual depositors to $250,000 through December 31, 2009 from the previous $100,000 limit. On face value, this may sound great but as of August 31, 2008 the FDIC insurance fund is quickly depleting:
Exhibit # 3 – FDIC Insurance Fund
The fund has depleted over $17.625 billion in less than one year and we have yet to take into account the forth quarter of 2008 which should be out shortly. It is stunning that they can simply increase insurance upwards to $250,000 while the fund is quickly going to zero. Of course the implicit guarantee was made from the U.S. government to back up these funds.
The FDIC has been careful about announcing troubled institutions. In fact, they only have slightly over 100 of those 8,384 institutions on the list which surely will grow. Let us look at the assets of those trouble institutions:
Exhibit # 4 – Assets of FDIC troubled institutions
From last accounting, $115 billion of assets were at risk. These banks are very likely to have problems and without a doubt, we will exhaust that remaining $29 billion in 2009. Meaning, the government is going to have to dish out more money. Money which we don’t have which of course will miraculously appear from helicopters.
Why am I so certain more banks will fail this year? Just look at the composition of banking assets:
Exhibit # 5 – Loan Portfolios
Residential will continue to have problems. Most of the bailouts have been focused here. But what about the large portion of commercial loans? What about the construction loans? What about the consumer loans? Credit cards? Are we going to bailout all these areas. Residential only makes up 26% of the loan composition of banking assets which the FDIC covers. That $29 billion is puny to what is at risk here. The growth in commercial real estate loans is what is going to sink hundreds of banks in the next few years:
Exhibit # 6 – Construction loans pose biggest problems
As you can see, banks went wild with construction and land development loans. They hit growth peaks at the height of the housing and credit bubble in 2004 through 2006. This is not good. The rate of growth was actually higher than that with residential loans which we are now seeing blow up. These construction loans have very little chance of making it through this crisis. Meaning, many of these loans will default. Many banks simply do not have the balance sheets to survive 2009.
And failures are already rising:
Exhibit # 7 – Bank Failures Rising
What you’ll notice is actual new charters has fallen and mergers and failures have gone up in 2008. Expect more of the same in 2009. The list of problem institutions grows by the day:
Exhibit # 8 – Problem institutions growing
Many of the banks started holding onto adjustable rate mortgages instead of fixed mortgages over the past few years. Now, we are seeing a spike in fixed rate mortgages because this is the only thing the government will now back:
Exhibit # 9 – Growth Rate of ARMs
The derivatives market is such a fantasy game. Take a look at this chart:
Exhibit # 10 – Commercial bank derivatives
This is flat out absurd. The notional value of swaps is approximately the size of 2 times annual global GDP. Don’t expect banks to pay one another. It is now a race between destroying the U.S. dollar and asset value destruction.
What can you expect in 2009? I think the above charts tell you the entire story. Expect commercial and construction real estate loans to bust with less of a safety net than residential loans and expect more bank failures and mergers. There isn’t much that can be done here except to flush the excess out of the system.
