Martin Feldstein’s column, (June 29, 2009) on inflation opines that while federal stimulus is still necessary, a combination of looming deficits, federal reserve bond purchases, and skittishness of foreign investors are pushing yields on the 10 Year Treasury up to alarming levels.

Feldstein’s major premise is detailed in the second paragraph of his column: Higher Yields have led to higher mortgage rates, reducing home buying, depressing net worth tremendously in the last six months. Further, lower home prices have caused more defaults and “weakened bank balance sheets”.

Lets correct some facts: Between 2006 and Six Months ago (December 2008), house prices dropped 27 percent. From December 2008 to March 2009 - the latest month of data,  housing prices fell comparatively 7%. Further, August 2009 Futures for Case-Shiller Composite index is currently trading at 152.0 slightly above where the index level stood in December of 2008, bookmarking the recent rise in treasury yields.

Feldstein, in his column, notes that the current spread between 10-year TIPS and 10 year Treasuries shows an inflation expectation of 2% annually. That inflation predictions have “jumped” to slightly over 2% per year is hardly alarming. 2% is often seen as an inflation target. That the jump in rates is perpetrated by fears foreign investors may no longer continue to buy US debt is simply not true.

China, most notably, while making loud noises is in a “dollar trap”, argued most notably by Paul Krugman. Fail to purchase US Treasuries, and decline the dollar’s value, making our goods cheaper and China’s goods more expensive, ending China’s competitive advantage in manufacturing.

At a high-level, if manufacturing in China continues to keep durable good costs down, and the Federal Stimulus package will improve roads and cargo lines, reducing transportation costs, price increases outside of energy spikes are hard to imagine for durable goods measured in CPI.

Perhaps Feldstein’s view of investor skittishness and his call for the Fed to assure the markets it will curb future “inflationary lending” are really directed at asset inflation: Perhaps investors believe that while policy makers are acting vigorously, nothing structurally has or is going to change to prevent another asset bubble similar to house price inflation witnessed over this past decade.

Asset inflation, be it houses or equities, is much harder to prevent than inflation in durable goods. Let us hope our fiscal stimulus and monetary policy are giving the economy surer footing to produce more, sharing those productivity gains across a wider spectrum, ensuring a diverse economy in the odds of preventing future asset bubbles.

Paul Krugman writes this week about the Irish Economy. In his column and blog, Paul notes Ireland is painfully transitioning, raising taxes to keep its fiscal position in line.

Let’s pause. If you have not read Lords of Finance yet by Liaquat Ahamed, stop reading this blog (or any other) and give the book a go. It is the cornerstone to understanding the current economic/financial crisis and comprehending possible solutions of both short and long duration.

In Lords of Finance, Ahamed writes of an eerily similar situation during the 1920s when Great Britain, starved for credit to funds its fiscal deficits, had to seek tacit approval from the House of Morgan on its proposed budget. Upon approval, Morgan helped raise a consortium of funding to help Great Britain stay afloat.

No doubt the same conversation was probably occurring in Ireland before it made its proposed increase in taxes. In the months since the world Financial Meltdown, Ireland raised debt in November 08 ($4bn),  January (Euro 6bn), and February (Euro 4bn). Then on March 30, 2009 Standard and Poors dropped Ireland’s sovereign credit rating from AAA to AA+ with a negative outlook. Since then, Ireland has not tapped the capital markets and has now tightened its fiscal belt.

This is now the choice of Ireland and other European Countries with current account deficits.  There is an immediate need to shore up the balance sheet, repay existing debts, and wait until domestic prices decline to a point where goods and services are competitive enough to be readily exported, regrowing the economy.  But waiting for prices to decline is a very painful phenomenon. Prices only decline when demand drops and a drop in demand across the board is synonymous with higher unemployment.

Ireland may be a small country (GDP wise), but its decisions are no different than California’s or many other states and municipalities here in the US. Without complete currency control, acting prudently (although potentially not economically), is the only choice to continue to tap existing capital markets, paying teachers, fire fighters and policemen. Economies in trouble and with a net debt position and complete currency control would either see a currency devaluation (in the form of a crash) or would choose to devalue their currency. Currency devaluation would hopefully occur faster than responsive domestic inflation allowing goods to be exported at a more competitive basis. Yet without currency controls, deflation is the only mechanism to getting prices to a point where exports can repay existing net debts (assuming those debts are denominated in the domestic currency).

Ireland is being used as an example of when economies are too reliant on the financial sector. To be clear, robust capital markets are critical to any functioning economy. Yet it is also important to note the following function: The limits to the magnitude (1x, 2x, 3x) of a sale of any business are equivalent to its estimated Rate of Return on Assets divided by its weighted average cost of capital - In a simpler Mogdliani Miller world this is the rate of asset return divided by the sum of the funding spread above the risk free rate and the risk free rate of return. In other words, the numerator to any business sale is the Rate of Return on Assets and the denominator is the return a new buyer is willing to accept. In the last eight years, we’ve grown because of the denominator: capital became cheap and offered increasingly attractive multiples for business transactions. In the next eight years, we must focus on the upper bound, the return on assets, the productivity of the country and its ability to make goods and services, representative of its currency.

Paul Krugman, in a blog post last week, offers an explanation for how private investors would think about asset purchases under the treasury plan. With no disrespect, here is my explanation:

Assume the purchase of a “legacy asset” (or purchase of a toxic asset, or the purchase of a pool of subprime mortgage) is a the purchase of cash flows for a period of 20 years. Many mortgages go out beyond 20 years, but let’s keep this at 20 for argument’s sake.

How much would I be willing to pay?

Well, a review of march-27-world-bond-yields, with at least an A rating, that go out 20 years, make me think I should get at least 8%. So, if I buy that asset for $100.00 (for which it is valued on the banks books), I’m expecting annual cash flows of $10.25 for the next 20 years.

It is fair to say, that given the horror stories everyone has heard about subprime mortgages, one would need a return far greater than 8% in order to buy one your own.

So the Treasury and the FDIC step in, and debt financing for up to 85% of the assets, with a matching equity contribution.  Assume then that the FDIC is able to offer 85% of the price on a non-recourse basis (meaning no other assets of me, as the the investor, would be touched eg - my home, my car should I be unable to service the debt). Then assume the FDIC offers 5% financing for the full 20 years. This, however, is a big IF, based on the Legacy Loan Terms sheet offered by the Treasury. Rates and Length could be far less generous.

Yet, if I were to receive 5% and 20 years of FDIC debt, my pre-tax return as the equity investor would be ~21%.

Assuming the FDIC offers these terms, the question then is, is a 21% pre-tax return to equity enough to entice investors to buy bank assets at their listed price? Secondly, is the program, with loans and equity contributions enough to remove the glut on bank books and get lending activity going again?

If the answer to either question is no, then the program has not (by itself) done enough to re-gain control of the credit markets, restart lending, and grow the economy.

But back to the 21% return for a second. In an article earlier this month in the FT, there were some pretty grim statistics about households behind on their mortgages. Nearly 12% of all home loans were either a month behind or in foreclosure. This statistic across of all households, but imagine what it is for those carrying “subprime” mortgages. Was this statistic modeled into the asset, valued at $100, on the bank’s books? That is not clear. As the equity investor, if I stress tested not receiving 12% of my cash flows annually, just to be conservative, my equity return under this scenario drops down to 12%. Given that this is a subprime mortgage pool, it could be fair to say, this investment is now not worth it.

Suppose then that a 21% return is the magic number. How much, assuming my stress test, would I offer a bank then for a $100 asset? The answer is $90, or a 10% haircut. The final question then is: Is losing 10% enough to to entice banks to still sell and remain solvent? Again, if the answer is no, then the program has not helped get lending going again.

Reading over this plan, it is my assessment that it will take time to start this program and get it functioning. The key then will be: what might happen in the mean time to banks and the economy and will we need a new set of assumptions to value these assets at that time?

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.

It is time to take stock of where the market sees the economy moving in 2009. Let’s examine

• Overnight Index Swap (OIS) Futures - tracking the effective Federal Funds rate
• Three-Month Eurodollar Futures - tracking three month LIBOR - the base private lending rate
• Oil Futures - tracking energy
• Dow Futures tracking industrial performance

2009-economic-indicators1

Let’s start with the base of the economy, the effective Fed Funds rate. By reviewing OIS Futures, the Market believes by the fall of 2009, the Fed will have increased the target funds rate to 0.5%. Further, economic activity will be strong enough that the effective rate will mirror the target rate by both the midyear and by the end of the year. Treasuries expiring in December 2009 yield 0.41%, according to the Wall St. Journal, close to the effective funds rate Dec-09 futures.

Three Month Eurodollar futures, a mirroring instrument to 3 month LIBOR trading on the CME state marginal increases in lending cost.  Considering treasuries expiring in March 2010 yield 0.4% (compared to treasuries expiring in December 2009), there is still a very high TED Spread - the private capital trust spread -by the end of 2009.

Oil futures-according to the Wall St. Journal-  show robust increases in energy cost. Further, according to the WSJ, there is no change in Dollar futures against a world currency basket through 2009. This shows a pickup in world oil demand, potentially a pickup in global economic growth.

The Dow, however, points down. This could be explained in two ways:

• The first is inflation. According to the FT, the Five Year Treasury Bond trades at 1.51%.  According to the WSJ, Five Year TIPS trade at 2.65%. Declining prices mean declining profits, which pushes down share prices. Declining prices coupled with increasing energy further pressures profits.
• The second - compounded with deflation - is the cost of debt. Fair to say, this fall was miserable for bond offerings. This past week was positive - companies actually went to market- weekly-bond-issues-ft-january-5-9-2009 - but for those companies able to issue debt, it is expensive, especially relative to treasuries -as mentioned before - of similar duration.

In 2009, the market predicts a start to economic recovery. That the fed funds effective rate will mirror the target rate and that the target rate will increase by end of 2009 shows positive economic activity. While 3-month LIBOR is low through 2009,  the actual cost of debt to firms - both in spreads and the growth/contraction in inflation - still puts long term pressure on economic growth.

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.

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.