The Federal Reserve released its combined 2008 Financial Statements on April 20, 2009. 2008 was stunning, with the balance sheet growing from $915 billion to $2.245 trillion. The major increases were in the commercial paper facility, foreign currency swaps, and term asset backed facility. Essentially - stabilizing mechanisms for short term market operations (both foreign and domestic) to continue.

The increase of $1.33 trillion is slightly larger than the gain in US GDP from $13.178 trillion to $14.264 trillion from 2006 to 2008. Essentially, the gains in US GDP from 2006 - when the Case-Shiller Composite Housing Index reached its peak - to 2008 are now sitting on the Fed’s books when they should be out in the private economy, on the balance sheets of companies, creating the next wave of products and services.

There are those who have argued the Fed’s actions will cause tremendous inflation. It is important to remember the major actions of the Fed are all preventing short term credit disruptions, which if not collectively implemented,  would have all lead to price declines, deflation.

Currency Swaps, worth roughly $553 billion or 1% of world GDP, are held against a basket of G-20 currencies, have most likely prevented an increasing demand for dollar. In the fall of 2008, the demand for the dollar reached a recent record high. Further appreciation would have further pressured US producers, unable to compete on price for various goods/services. The only solution would have been to cut costs to reduce prices.

Commercial Paper, worth $333 billion, is necessary to keep working capital afloat. Without it, the only solution to meet existing funding needs or return previously funded commercial paper would have been to liquidate existing inventory at reduced prices.

Term Asset-Backed Facility (TAF), worth roughly $450 billion, is further short term financing to allow banks to continue liquidity while suffering losses on their longest duration assets - CMOs. Without access to short term financing, again the only choice would be asset liquidation, further forcing price declines.

True, CPI did not increase in 2008. But added together, the Commercial Paper and TAF are roughly 5% of US GDP. As most companies were levered to the tilt, if the Federal Reserve funding was not there, the US price and consequentially unemployment situation would have been far worse.

As to worries of runaway inflation, the jury is still out. My belief is that the capital these facilities are replacing - in a sense - is now shoring up the balance sheets of various banks and companies. By increasing  equity ratios at companies and banks, future invested dollars from these newly shored up institutions will need higher returns on capital (all else equal), which is equivalent to the Fed raising fed funds rates to control inflation.

Until a recovery though, it is a good thing our economy has not faced deflation, certainly a real possibility in the fall of 2008.

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.

Much concern exists over Obama’s proposal to make tax cuts a major portion of fiscal stimulus.  Through a tax cut, we (the government) are increasing the income of those still employed. Hopefully, tax savings will buy goods and services, increasing GDP. In today’s environment, we’re not enacting a stimulus to buy goods, we’re enacting a stimulus to buy jobs.

GDP = government spending + investment + consumption + net exports. The marginal dollars in a tax cut will either be saved or spent.

While savings should be encouraged in the long term, a savings glut currently exists. Fed Funds rate trades near zero, while cash reserves within the Fed have ballooned.

More damaging, marginal spending could be directed at imported goods. From Martin Wolf to Warren Buffet, many shudder at no improvement in our trade balances. Dollars used for imports are either locked up as foreign reserves or exchanged for investments in future US cash flows. Those future cash flows are either US tax receipts or profits distributed as interest or dividends. Those tax receipts could have put new teachers in the class room. Those profits could have built new factories. Those cash flows will never to be re-invested in the US.

By definition then, an increasing current account deficit means the same standard of living - GDP - costs more. If this is not the purest form of inflation, I do not know what is.

Many believe  too great a mismatch exists between jobs lost and jobs needed for “shovel ready”.  Cokie Roberts on “This Week” opined on finance professionals helping on infrastructure: “Well maybe instead of going to their personal trainers, they can actually get out there and start digging.”

The purchase of infrastructure projects buys jobs across the food chain.  Almost every project will go out for private competitive tender. Forget defunct residential home construction (shovel ready employees), companies bidding will require talent to prepare bids, obtain financing, manage payroll, and review costs. Every contract guarantied by the government (state or federal) will give lenders the confidence to finance, spurring new growth.

The long term benefits (aside from jobs) are then improved transportation, reduced energy costs and reduction of barriers to education. Thus reduction of risks for future runaway inflation - those risks prevalent in increasing current account deficits. Faith in government is presently difficult yet now we must make our congress the direct investors of last resort.

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.

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.

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.