After the stimulus bill passes, President Obama and Tim Geithner will propose the next bank bailout. The concept of the bailout is the “bad bank”: Toxic assets are lifted from the bank balance sheets so lending can resume.

The key to stimulating lending is to resume interbank lending. Interbank lending can not fully resume until banks are comfortable their bank counterparts do not have any toxic assets, which under-performance could trigger a default. A default would make it difficult for the lending bank to receive its cash.

Look at the LIBOR yield curves on

feb-9th-2007-interbank-lending

feb-6-2009-interbank-lending

The steepness of today’s yield curve shows how skittish banks are in lending money for long durations, including one year.

Many worry the “bad bank” will cost the taxpayers money. Banks will not sell toxic assets for their true worth. Yet if banks agree to sell, many fear the taxpayer will pay too much. These “toxic assets” are packaged “subprime” mortgages. As job losses continue, home prices continue to decline and defaults continue to increase. Volatility makes valuing these assets almost impossible. Worse, this volatility is starting to damage mortgages further up the food chain.

Restarting the ability to make these mortgages worth anything are the following two statistics.

1) Real Median Household Income has not increased since 2000 - incomeinamerica1

2) Since 2000, The US Current Account Deficit has increased as a percentage of World GDP

Since consumers are (were) 70% of the US Economy, any increase in home values in the bast eight years has been on the backs of household borrowing. Until US Families can annually earn more, home values and mortgage portfolios will not follow suit. Homeowners need to pay back existing loans and earn more for future consumption at the same time.

The economy that increases real median household income is the next question. The recent share, both overall size and contributions to growth of the Finance Sector, contributed to our current state.  This is not assigning blame. We need capital to back people, ideas, bringing improvements to today and tomorrow’s economy. But we need to make more than financial products if we are going to lead the world, resume growth, and further pay for social security and medicare/medicaid.

Which brings us to the bailout. Must we do something? Yes. But lending can not resume to its 2006/2007 state unless we have an economy with a stronger manufacturing base to support it. Leverage on leverage only brings defaults and further trouble.

That is the challenge of this administration and the the private sector -aka - everyone. If we can create an economy that creates wealth for everyone, our future will be far brighter.

Yesterday’s news was not encouraging. Home value declines will continue to make families and home owners second guess their net worth. In a recession, this prompts only one reaction: saving.

The macro economic accounting identity states savings equals investment. This static steady theory is becoming a large force against fiscal stimulus, now awaiting Senate Approval.

Let’s review the facts. With the Fed meeting today, Fed Funds ended trading at 0.18% according to the Financial Times. As rates are not able to go below zero,  interest rates are essentially fixed. And bank reserves held at the Fed increase. There thus is no further mechanism to force private investment to equal savings.

As savings not offset by investment (which would lead to new jobs) and unemployment increase, taxes decline. If government expenditures just stayed the same, our federal deficit would have to increase, even without fiscal stimulus.

Faced with the choice of

• Large Federal Deficit
• Infrastructure Investments => New Jobs and a Large Federal Deficit

Its best to choose jobs, new infrastructure and a large federal deficit.

Today’s news was even less encouraging. That jobs are lost in record numbers makes valuing mortgage bonds, even if simply constructed, even harder. Yet mortgage bonds are not simply constructed, they are incredibly complex.

Job losses will not decelerate for a while. It will take time for fiscal stimulus to take effect. This makes the idea of the “bad bank” incredibly complex. Many like Reich still hold out hope for a solution that protects the tax payer. The economic reality makes it impossible that mortgage assets still on the books are worth anything close to what they were previously valued. To unclog lending, we -the taxpayer- must further take it on the chin.

Yet as the fiscal stimulus and bad bank solutions work through the economy (and slowly), we must ask ourselves: what kind of economy do we want to now create? Should the Financial Sector contribute 31% of GDP as it did in 2006?

Which should we value more? Financial engineering or mechanical engineering?

This is again why infrastructure investment as the stimulus for tomorrow’s economy is so important: The only way long term balance will be restored (and one could measure this by the current account balance) is to choose engineering over financial engineering. The more we build (not out of paper) at home, the more our economy will grow in a balanced, mature way for generations.

As Congress released the second round of TARP funding this past week, anxiety grew that its original purpose is failing: banks are not lending.

To discern why, we must think about the relationship between the TARP funding requirements and Federal Reserve Monetary Policy.

With banks taking write downs during the fall of 2008, its plausible to assume TARP funding was the only new source of capital - all remaining bank liabilities and assets were matched after write downs, tied to existing economic activity. The only source of capital for new economic activity was TARP funding, now $700 billion. To give comfort to this assumption, add up the market capitalization of the largest US banks - far smaller than TARP.

By law,  TARP funding is preferred equity on a bank balance sheet, with a 5% annual dividend. Add on administrative costs, and a loan just to break even needs approximately 6%, just to service the taxpayer requirements of TARP. Yet through Open Market Operations, the US Ten Year Treasury currently yields 2.34%, according to the Financial Times and the effective Fed Funds rate is 0.18%. TARP funding requirements place this large source of new capital no where near this historically low yield curve, completely at odds with Open Market Operations.

Two years ago, overnight treasuries traded at 5%. When the economy grows at 3% per year, an inflation at 2%, a business owner merely switches on the lights to pay back a 5% interest bearing loan. Yet in today’s environment, 5% is expensive. In today’s environment -a ZIRP interest rate environment - a recessionary environment - a deflationary environment,  those willing to accept north of 5% (6%) is a classic adverse selection problem: The smart businesses horde cash as new cash is too expensive. The businesses accepting such a loan may not be able to pay it back.

Faced with the prospect of new bad loans, it is no surprise banks are not lending. They would rather preserve capital to plug foreseen bad loans in the coming year. Further, to achieve 5%, M&A is a preferred method, scooping up the right loan packages at the right price.

A Solution:

This page has long argued TARP dividends should be a rolling average of the yield on treasury bills/notes - the opportunity cost of taxpayers funding the banks. If yields are low, economic activity is weak, keeping dividend payments manageable. If yields are higher, (assuming no runaway inflation) economic activity has increased as treasuries were sold for corporates, again making dividend payments manageable. We hope the new administration makes this change.

The Yield Curve is increasing in discussion as a predictor of the US Economy.

First, in defense of the Yield Curve, it is a good predictor of future short term interest rates. Let’s take the UK and the US current short term Yield Curves, courtesy of the Financial Times.

The UK Yield Curve:

The US Yield Curve:

• The official UK Central Bank interest rate stands at 2.00%
• The Fed Funds target rate stands at 0.25%

With similar economies -troubled financial sectors, and nerve racking current account deficits -there is almost no question the UK will mimic its “special relationship” counter part and further slash interest rates to boost its economy. Hence, the UK curve slopes down in the short term.

Recovery:

Now, let’s read the yield curve tea leaves for the US economy:

• The Cleveland Fed votes yes
• Paul Krugman votes no

Paul is right. That the “effective rate” of Fed Funds trades at 0.14%, mirroring overnight Treasury Bills means the yield curve can only slope positively (The UK curve highlights why Paul is correct). Two years ago, life was much different.

• Fed Funds “effective rate” was 5.30%.
• Overnight 3m Treasury Bills traded close to 5.00%.

That the 30 Year Treasury Bond trades today at 2.81% shows a very weak economy, regardless of the slope of the curve. Further, it shows a long time until economic recovery. Larger economies require larger yields to balance the supply and demand of money.

When investors resume believing in corporate bonds, the yield curve will start to increase in slope. Treasuries will be sold and corporates will be bought. The key to economic recovery will not be the purchase of existing corporates - most of those were sold when yields were low. Rather, the key will be when new corporates are issued and issued cheaply (low yields). This will start putting new profits (more return on equity) back to companies for investment and further economic growth. Unfortunately, it has been a very light fall and continues to be a light winter for new debt issuances.

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.

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.

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.

The Fed Open Market Committee recently announced the extension of its December policy meeting from one to two days. With extra time, I argue the Fed should strongly consider cutting the target Federal Funds rate from 100 basis points (where it currently stands) to 25 basis points.

• As I predicted in Note Twelve, overnight LIBOR has converged upward, reaching the target Federal Funds rate of 1.00%. This is because the Federal Reserve now pays interest on all “excess reserves” banks now park at the Fed.
• A look at TIPS vs. Treasury Yields over the next year still shows wild expectations of deflation. Ergo, even though banks’ excess reserves receive a measly 1.00% by doing nothing, they make larger returns in this environment.
• Though the Fed is paying the target rate for excess reserves, the effective Federal Funds rate still trades at 59 basis points, according to the Financial Times. This is because our Government Sponsored Entities can not receive interest from the Fed on their parked capital. With no bank wanting to use their funds, the Federal Funds effective rate declines further from the target rate.

Most “Fed Watchers” expect a 50 basis point cut in December. As you can see, we are already there. A further cut of this magnitude are moot.

A semi-coordinated solution:

Between the Fed’s recent program and the Treasury’s TARP program, we are going to “borrow and spend” (or print and spend) a further 10% of GDP on “unclogging the system”.

• The TARP program should be injecting enough preferred equity capital to improve bank balance sheets. Yet lending has not picked up, as I argued in Note Twelve.
• I believe the new Fed program should help eventually reduce excess Government Sponsored Entity capital sitting at the Fed by buying mortgage backed securities guarantied by Fannie and Freddie. But it is too soon to tell.

Therefore, the FOMC needs to triangulate a strong signal, telling the banks what all pundits, bloggers, and congressional representatives have been saying for some time:

“Get your capital out of my bank and start lending!”

At 50 basis points, I have argued we would see no change from the current situation. Cutting the Federal Funds rate to 25 basis points should hopefully force a change in bank behavior. Fed rates would just be too low, even with deflation expectations, for opportunities not to be exciting. With it should force excess reserves out of the Fed and back into the the market at essentially risk-less rates.

Cut the rate to 25 basis points and Happy Holidays!