Posts from — December 2008

What will 2009 look like? This blog offers key spreads to examine routinely for signs of economic recovery. In chronological order

• The Fed Funds Effective vs. Target Spreads.
• The TED Spread
• LIBOR vs. Investment Grade Bonds

Fed Funds Spread

The Fed Funds Spread, the difference between the “Target Rate” and the “Effective Rate” for Federal Funds is essentially the measure of slack in the economy. Today, the Target Rate is set to 0.25% and the “Effective Rate” for overnight funds trades at 0.11%: banks can not find enough opportunities (or see too much risk) to lend. Instead, banks choose to keep excess funds within the Federal Reserve.

This is the first spread to watch. When the “effective rate” trades at the “target rate”, the economy is performing to its potential in the current interest rate environment.

The TED Spread

The TED Spread, the difference between three month LIBOR and three month US Treasuries, is essentially the measure of trust between the private and public sector. According to the Financial Times, three month LIBOR trades at 1.47%. Three-month Treasuries trade at 0.0014% (zero). That’s a big spread.

This spread can not converge until overnight LIBOR -which mirrors the Fed Funds “effective rate” - trades at the Fed Funds Target rate: Effective Rate vs. Target Rate convergence implies upward pressure on treasury yields, making overnight treasuries trade at a minimum of 0.0025%.  This is the start to redeeming trust in the private sector vs. the public sector.

LIBOR vs. Investment Grade Bonds

This spread measures competition and confidence in the private sector’s ability to earn income. Today, one year LIBOR trades at 2.09%. Reviewing Global Investment Grade Bonds from the Financial Times, most trade at ~6.00% yield.

global-investment-grade

This is the final spread that will show uptick in the economy. When this spread converges, trust in corporate earnings is restored: the public market respects corporate earnings enough to offer a suitable substitute to banks as a source of debt funding.

The LM Curve as Perspective

Reviewing the LM curve, demand for money equals the supply money at a given output and interest rate - in this case a zero interest rate environment.  Output could increase in a zero interest rate environment, with expansion of the money supply (as the Fed is currently doing) and with expansion of the government spending (as Obama is planning). Given we are in a contractionary economic environment, one could argue the US has only slid down the LM curve - money supply expansion has not worked -, awaiting a shift in the IS curve with new fiscal expansion.

However, a healthy economy has demand for money at positive rates. For this we look to the convergence of the spreads listed above.

This blog has focused on the FDIC insurance program guaranteeing newly issued bank debt.

Here is why:

Reviewing the facets of the right hand of the balance sheet, the taxpayer and printing press are very active.

• Short Term Liabilities, Commercial Paper - Guarantor - The Fed
• Short Term, Long Term Debt - Guarantor - The FDIC
• Preferred Equity - The Treasury

This blog believes the FDIC program is the most powerful government program helping banks currently expand credit.

A lot has been written on Credit Default Swaps. These unregulated instruments were instrumental in causing a crisis of credit, in turn causing a crisis of economic performance.

Let’s examine where these two issues meet: The Fee the FDIC charges banks to guarantee their new debt. This fee is the Credit Default Swap the FDIC (aka, the US Taxpayer) sells to guarantee new bank debt (from Goldman Sachs, Morgan Stanley to John Deere Capital).

What should the price of the swap be? Evidence from one source this month says as high as 7% or 700 bp annually of principal. The FDIC begs to differ. For any debt issued and set to expire more than a year from now, the FDIC is selling a CDS for 100bp, or an annual 1% of principal. While the CDS market is not transparent enough to determine the true price, it is fair to say 1% is cheap, or subsidized.

Is this enough? Is it even necessary to charge a fee or subsidize the entire swap?

• The FDIC states this program will be of no cost to the taxpayer.

• Right now, the FDIC has ~$33.4 billion in the bank, to guarantee this program as well as all accounts now $250,000 or less.

• Let’s assume most outstanding bonds covenants are written to ensure seniority is universally established in the event of a default.

• For the big banks, would the taxpayer just guarantee the debt sold with the FDIC swap? Comparing Lehman to Citi, the answer is probably not.

• Finally, given the lack of public savings, the taxpayer will have to return to the debt market should any bailout be necessary.

Is the FDIC program helping to fuel cheap credit? Yes. But given the US Fiscal Condition and its new precident of response to a crisis, the taxpayer should realize it is selling underfunded Credit Default Swaps just like the banks it now stands behind.

Preparing for 2009, this week marked a terrific example of de-leveraging in practice.

• As of Friday, December 19th, according to the Financial Times One year US Libor was 2.09%
• As of Friday, December 19th, according to the Wall Street Journal, no Treasury expiring prior to 2015 yielded more than 2%.
• And, as of Friday, December 19th, according to the Financial Times, the Fed Funds effective rate was 0.11%

So, there has never been a cheaper time to borrow, right? Only if you have an FDIC (taxpayer) stamp next to your offering. Take a look who issued debt this past week, courtesy of the Financial Times.

Financial Times: Week ofDec-19th-bond-issues-us

One side note: Even John Deere Capital got into the FDIC mix! So don’t tell GM and Chrysler they can’t have taxpayer loans.

According to the WSJ, this week was the final week in 2008 for private bond offerings. The lack of Corporate Debt issued should provide guidance that the US Economy (by force or by choice) is continuing its de-leveraging.

Final side note: According to the Wall Street Journal, The Illinois Finance Authority is set to offer $500 million in bonds on December 26th. Though it is independent of the State, this should be an interesting post-Christmas verdict on Governor Blagojevich.

While this is way outside the scope of this blog, a vocal “boo!” to this growing trend: 401K Matching Cuts

• Essentially guarantees Americans will retire later in life.
• For everyone hoping Federal Fiscal Stimulus will pull us out of economic morass, this will only decrease already skittish household consumption as families will no doubt save more, lowering GDP growth.

As predicted, the Federal Reserve Open Market Committee (FOMC) dropped its core interest rate by 75bp. A surprise to many, not to this blog. Enough bragging, these are scary times:

• The first reason is the FOMC statement: “The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent”

A target range? This is the first time in recent memory the FOMC has stated it would establish a range and not a specific rate for its open market operations.  The minutes of this meeting will be very interesting:

• This blog will predict that the FOMC will admit it has lost control of the Fed Funds rate.

And that is very scary. Even though the Fed now pays interest on reserves, instead of only buying short term treasuries -, the actions to control the Fed Funds rate are not working: There is no demand to use capital in this economy: From the Financial Times:

• The Fed Fund rate sits at 0.12%, remaining unchanged from before the rate cut.
• Overnight LIBOR is 0.0115% (because the Fed pays interest on reserves)
• Overnight 3m Treasuries are 0.01%

Deflation:

Reserves sitting at the Fed have ballooned to almost $700 billion, comparable to envisioned TARP program.  Yet that money is parked there most likely because the Fed has been gobbling up Treasuries, driving the yields to zero. It is not going outward into the economy.

If you believe in Milton Friedman, then you believe the following:  Without lending activity and expansion of the monetary base - demonstrated by these spreads - then at best, the money supply is not keeping pace with the economy. Therefore, deflation.

It might be worse. If the expansion only sits in existing treasuries, and those treasuries are not new issues for new government programs - aka - the stimulus, then all we’ve done is increased the demand for treasuries and done nothing to expand the economy. Further, remember the taxpayer has only saved money from the latest treasury issuance. Other issues had more expensive yields. In a deflationary environment, this problem is only compounded. 

Until the stimulus is enacted, we must expect a deflationary environment for at least the short term. And that will cause the FOMC to continue its inabilty to control the Fed Funds rate.

Dec 15th and 16th are when the Fed meets for the final time in 2008, when it will decide how low the Fed Funds rate should be.

No ordinary time:

1. The Fed Funds Rate sits at 1.00%. But the Effective Rate as of Friday, Dec 12th according to the Financial Times was 0.14%
2. Fed Reserves normally are $800-900 billion. Today there are $1.5 trillion in Fed Reserves, according to The St. Louis Federal Reserve.
3. Treasuries normally pay positive interest rates. According to the Financial Times, overnight rates for three month treasuries are paying 0.03%. Further, the latest auction showed people are willing to pay the US Government more for less in the future. (deflation).

So what should the Fed do?

• Conventional wisdom leading up to this meeting was that the Fed would cut interest rates by 50 basis points from the current 1.00%.
• I argued in a previous post that only a 50 basis point cut would do nothing.
• Now, the expectation has shifted (maybe thanks to my Note….just maybe). CME Fed Binary Options prices as of Friday, Dec 12th show the market is betting on a 75 basis point cut.

The three major reasons against a 50 basis point cut are as follows:

• For some time, the effective Fed Funds rate has been trading below 50 basis points, making a 50 bp cut moot.
• With demand for Treasuries now essentially inelastic, part of the Fed’s open market operations are simply ineffective.
• Since the Fed’s rate cuts in the fall, bank lending has not responded. I argued in Note 16 one way to view this. Here is another: A look at the St. Louis Fed research shows M2 has remained largely unchanged from October 20th to December 1st. We need a resounding effort to get capital out of Fed Reserves and into the private markets.

A 75 basis point cut will occur by Close of Business, Tuesday the 16th.

But a 75 basis point cut may not help all that much without a spur of domestic demand.

• St. Louis Fed research shows corporate Aaa bond yields have remained largely unchanged over the fall: While base rates have declined, spreads have widened.
• The Commercial Paper Market has dramatically shifted from private market consumption to the Fed. According to the St. Louis Fed, in October, the figure of borrowing from the Fed was $450 billion. Today, it still is over $250 billion.
• This week, according to Financial Times data,  The American Express -now- “Bank” jumped on the bandwagon of FDIC backed debt raising, floating $5.5 billion of debt at yields of 2-3%.

In short, the Fed’s and other government’s massive expansion of credit market intervention is now more powerful than Open Market Operations. While the need for a 75 basis point is important and required, other actions are now more powerful to spur economic recovery.

Turning to 2009:

The fact-pattern above gives pause to how big a stimulus package needs to be vs. how quickly it needs to be spent. I am for a massive Fiscal Stimulus of at least $600 billion. But every dollar borrowed by the US Government (especially today) is a dollar unable to be accessed by Private Companies for new projects and investments, even in ZIRP land.

As Paul Krugman said today on “This Week”, it is hard to spend $600 billion dollars, even for the Government. Domestic Demand stimulus will only be effective therefore in boosting the private economy if “size” is optimally aligned with “velocity” and “accuracy of spending”.

Still, look for a 75 basis point cut this week as the final message of 2008 in preparation of massive fiscal stimulus in early 2009.

Robert Shiller, in his book The Subprime Solution offers a risk management tool for governments. It is a “Trill” and it pays a perpetual share of GDP.

As GDP increases, the instrument pays a higher coupon. During a recession, it pays less. Quite the floating instrument. Shiller assumes each share would pay roughly $15, believing perpetual GDP would average $15 trillion annually. (Hence the “Trill”). Each Trill would be worth roughly $300. This assumes the US Risk Free rate is 5%. The risk-less rate of the US economy is 5%.

The “Risk” that is managed is during hard times, the government obviously owes less in debt service costs. In times of plenty, the government can afford to pay more. But in bad times, governments would have more cash on hand to handle a crisis (such as today).

The Pros.

• This instrument allows the market to truly estimate GDP growth. In some ways, the instrument is worth issuing simply to have a market view (a great view) of GDP growth.
• One now has the ability- with TIPS, Treasuries, and Trills- to estimate real GDP growth given  market views.
• Instead of perpetual Instruments, it could be more beneficial to issue “Trills” expiring annually, similar to TIPS and Treasuries. This way, one could have the market truly predicting GDP growth.

The Reasons for Pause:

• Reviewing the LM curve, as output grows, interest rates rise. As the economy falters, interest rates fall. Even in today’s crisis, this relationship holds true. The Trill’s desired hedge already exists. Further, this means the government has the ability to re-finance higher yielding paper in tougher times.
• The Hedge: Shiller’s main reason for the GDP indexed Trill is to provide government “room to spare” should a contraction occur. As GDP declines, so would tax receipts, lowering government revenue. It then is hard to argue the Government would have spare cash to attack a crisis.
• Other Financings: GDP, remember, is defined as Consumption + Investment + Government Expenditure + Net Exports. GDP could remain stable year on year, but Imports could still rise. In this example, Investment (Foreign Direct Investment) remains unchanged meaning the Current Account Deficit is in the form of domestic bonds and stocks, essentially payments to foreigners from US income. Trill payments could remain unchanged, but the country as a whole would pay more to maintain the same standard of living (in the short run).

Robert Shiller is one of our smartest thinkers on real property. Let’s work on the Trill as it has definite promise as a positive instrument for US Debt.

As a follow up to Note 15, this week banks in the US issued $23.8 Billion more in FDIC (taxpayer backed) debt. This is on top of the roughly $17 billion issued last week. The total amounts exceed the reserves the FDIC has in the bank. Looking at where other debt is trading for major banks, the FDIC (the taxpayer) is subsidizing each bank (B of A, GS, Morgan Stanley, JP Morgan, etc.) by approximately 300 basis points.

First off, Happy Thanksgiving to you and yours!

Last week Goldman Sachs became the first “bank” to float a bond issue guaranteed by the FDIC.   A look at the weekly debt issues from the Financial Times shows US banks springing back into action, all issuing FDIC guaranteed debt. As I can tell, these are the first bond issues of any major financial institution in Dollars since Lehman’s declaration of bankruptcy.

(For the purposes of this post, all noted bonds sold close enough to par that coupon yields as first order approximations for true yields will suffice. Sorry Professor Jenter!)

• Goldman Sachs issued $5 billion due in June 2012 yielding 3.25%
• Morgan Stanley issued $2.25 billion due in Dec 2010 yielding 2.90% and $2.5 billion expiring in December 2011 3.25% and $1 billion due in June 2011, half of which has a known floating rate of   1 month LIBOR plus 74 bp.
• JP Morgan issued $5 billion due in December 2011 yielding 3.125% and $1billion due in December 2010 with floating rate interest of 3 month LIBOR plus 50bp .

Thanks to the FDIC guarantee, the yields on these bonds are very low, making them very favorable for the issuing banks. Yet the FDIC has only $34.6 billion in funds for this purpose or general insurance on accounts up to $250,000.

I would argue the FDIC’s funds are too small to take on insuring now larger accounts as well as guaranteeing bank bonds. So, the taxpayer is on the hook for  $16.75 billion of new bank debt.

Let’s put that amount in perspective.

• GM, Ford, and Chrysler are asking for $25 billion
• The net CDS exposure on GM and Ford amounts to $9.6 billion
• As I wrote in Note Four A, as part of the TARP program, the tax payer is due to receive roughly $18 billion in dividends from the first $250 billion the Treasury is injecting as preferred equity capital into these same banks.
• John McCain railed against earmarks all campaign long. President Elect Barack Obama said earmarks amount to $18 billion a year.

Further, it is important to compare the incredibly low yields on these bonds:

• In the week of November 7, 2008 Ireland, a sovereign euro denominated nation that stated it would guarantee all deposits from six of its largest financial institutions, sold 4 billion of euro debt, due in November 2011, yielding 4.0%

And during the Year of Cheap Credit, Fall of 2006-Spring of 2007 (without any FDIC backing)

• In September of 2006, Goldman Sachs issued 750 million euros due in October, 2021 yielding 4.75%
• In September of 2006, Citi issued 1.25 billion euros due in October, 2013 yielding 3.95%
• In February of 2007, three banks no longer in existence in the same form issued long duration debt:

1. Wachovia issued 1 billion euros due in February 2014 yielding 3 month Euro LIBOR plus 15 bp.
2. Lehman Brothers issued 1 billion euros due in March, 2019 yielding 4.625%
3. Merrill Lynch issued 1 billion euros due in February , 2012 yielding 3 month Euro LIBOR plus 18 bp.

Side Note: it is amazing reviewing that year of cheap credit how few bonds were issued in dollars relative to Euros and Sterling. It made me believe Mayor Mike Bloomberg was right to worry New York was losing out as the capital of global finance.

IN SUM: This is new uncharted waters for the US Taxpayer. What if one of the banks uses the funding to underwrite new acquisitions that create “synergies” resulting in laid off workers? What if the funds are used  to lever up a commodities bet? I do not believe banks raised enough capital to make single bets of that systemic threatening magnitude, but the overall point is this:

• In large part, banks and autos are short term inelastic industries. Without a bank, its hard to save currency and its hard to do commerce. Without a car in the USA, its hard to travel from point A to B.
• There are plenty of foreign banks and plenty of foreign car companies.
• I reckon between the FDIC, Treasury and Fed plans, we are spending close or guaranteeing close to $2 trillion, ~15% of GDP, for our private sector banking industry. While congress has made “noises” on insufficient bank lending, there is no plan attached to this funding. Yet produce autos and ask for $25 billion, you’d better have a plan.
• Bottom line for CEOs learning how to manage through a future crises: It sure pays to be the industry first in line for help.