The Financial Times and Goldman Sachs have put forth their long list for Business Book of the Year.  The  winner amongst the many terrific nominees should be Lords of Finance by Liaquat Ahamed.

That its richness in detail flows as easily as a Harry Potter novel is certainly laudable. It is the presentation of the cause and effect of monetary policy, its struggle to co-exist independently with its fiscal policy counterpart, and the depiction of the US Central Banking system in its infancy that make it mandatory to read in detail today. The composite presentation of key actions, key “inaction” and ignorance of bubble causing behavior are reticent today not only for comparing the similarities of the times, but further as a reminder of how fragile our institutions can truly become when put through such stress. As Mr Ahamed concludes in his final chapters, the story is further a stark reminder of the effects of prolonged economic despair.

If you have not done so, you must read Lords of Finance. It certainly is Business Book of the Year.

Robert Samuelson, (who in full disclosure was a former neighbor) writes in the Washington Post today blaming economists for misreading the current crisis, failing to give proper warning. Instead, they were “out to lunch”.

In my opinion, a more thoughtful, introspective, and productive piece on the same subject was written some SEVEN months ago by Martin Wolf of the Financial times.

Judge for yourself.

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.

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.

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.

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!

On a randomly selected May 16th, 2007, the Federal Funds rate was 5.25%. The effective rate (the rate bankers actually trade and negotiate at) was 5.29%. The actions taken by the Fed ensured its “target base rate” was the actual base rate for charged money. In short, this is our monetary system we take for granted, daily.

Before the credit crisis, how did the Fed ensure the spread between the target and effective rate stay so close to zero (if you know this, please skip down)?

• Banks are required to hold a certain amount of capital at the Federal Reserve. Prior to the crisis, a banking business model was to lend to outside parties. When lending exceeded required capital reserved at the Fed, banks had to borrow to repatriate to the Fed.
• The first choice of funds to borrow is capital held by other banks at the Federal Reserve.
• Should other banks charge too much for these funds, banks seeking capital could simply short treasuries.
• The Fed would mimicked this action,  buying and selling treasuries to ensure the market price for treasuries kept banks honest in pricing overnight lending.
• Sure enough, on May 16th, 2007, overnight LIBOR was 5.30%, one basis point from the effective rate and five basis points from the target rate.

Today, the story is quite different. The Federal Reserve’s target Federal Funds rate is 1.00%. The effective rate, (from the Financial Times), is 0.49%.

Two implications:

• Almost everyone surveyed, interviewed, and opining (including me) expects the Federal Reserve to slash the target rate from 1.00% to 0.50% in December. That decision is now moot.
• When the effective rate is nearly half the target rate and overnight LIBOR is 0.70%, in between the two rates, and yields on treasuries expiring on November 30th are 2.67%, there is a problem of illiquid markets, not responding correctly to simple centralized decisions attempting to steer the economy. To quote Senator Trent Lott, we are now “herding cats“.

How and why?

Reviewing the minutes from the last Federal Open Market Committee meeting and events of the “credit crisis” I find several issues:

• Randomly sampling daily market rates, the spread between target and effective rates was not large enough to be significant until after the bankruptcy of Lehman Brothers, on September 15th, 2008.
• By September 22nd, 2008, while the target rate was still 2.00%, the effective rate was 1.79%. By the end of that week, the effective rate was 1.21%. In short, capital required to be in the Fed was not going anywhere: thus the start of banks truly refusing to lend.
• So, the Fed on October 6th, 2008 started paying interest on held capital, attempting to establish a floor on effective rates. Most important, the Fed started to pay interest on excess cash held above any requirements.
• But by October 10th, 2008, the policy wasn’t working. While the Fed slashed rates from 2.00% to 1.50%, the effective rate was 0.90%.
• By October 21st, the effective rate hovered below the floor rate established by the Fed on October 6th, 0.73%.
• So, the Fed again in two different announcements, the latest on November 5th, raised the interest rates paid on excess balances. As of today, any excess capital receives the target rate.

We’re still in the same position and I highlight what is explained beautifully in a recent Financial Times article:

• Most of today’s spread is explained because our Government Sponsored Entities, Fannie Mae and Freddie Mac, hold reserves at the Fed. Yet they can not receive interest payments, and thus must lend their capital at the effective rate.
• As banks are queasy regarding their own reserve requirements, they do not want to borrow entity funds for opportunities.  This capital simply sits at the Federal Reserve, depressing the target rate.

The Bottom Line:

• BANKS ARE NOT LENDING. If Banks were lending, there would be no need to pay interest on excess reserves.  That capital would be privately lent, to businesses large and small, old and new.

The Fed now has de-facto set a larger reserve requirement for banks, by paying interest on excess reserves. This is very dangerous.  That excess cash that should be in the market, growing our economy. (As I heard in business school again and again “putting capital to work”).

While overnight LIBOR has trended up since the Fed’s latest announcement (from 0.33% to 0.70% and most likely will continue up to 1.00%), the larger problem is this: For growth opportunities of the US Economy, the same target rate on a larger reserve pool of capital is equivalent to a higher rate on the official “reserve requirements”.

Therefore, when the Fed does cut rates to 50 basis points, what effect will it have?

Is the liquidity crunch over?

Here is my thinking:

Let’s review treasury rates (aka, the “riskless” rates) for the US and UK over the next six months. According to the Financial Times data on November 14^th, 2008:

• US treasuries set to expire in six months yield 87 basis points (Deflation).
• UK treasuries set to expire in six months yield 199 basis points (who knows)
• One British Pound today is worth 1.4827 US Dollars
• One British Pound’s worth in six months as of today’s spot forward is 1.4807 US Dollars

The rates for sovereign taxpayer debt and the interlinking value in currency should display the differences in risk of each country.

• $100 invested in US treasuries vs. $100 invested in UK treasuries and converted at the corresponding spot and forward rates should yield the same rate of return.
• Converting $100 to pound equivalents, investing in UK treasuries, and returning those pounds to US Dollars six months from now returns a dollar more (.98 US cents) in value.

In normal times, no way. Someone in any trading house would be looking for the “blips” to quote Michael Lewis from Liar’s Poker. Here are a two observations why this opportunity exists today:

• As discussed in previous posts, we’ve witnessed massive flight to quality recently, as capital has left emerging markets and safe harbored itself in US Treasuries
• The REPO market continues to be stressful. Again, as discussed in previous posts, the lack of shorting treasury opportunities has caused massive spreads differences in otherwise equally risky cash flows.

What is interesting though is that the link between currency and risk still exists for the most part. For the UK though, that means its current treasury yields are tied far more to the US and the Dollar than they are to their own interest rate policy (currently at 3.00%). While the Bank of England has been aggressive in rate reductions, its own government bonds in no way reflect this.