• Right now, required reserves at the Federal Reserve stand at ~$64 billion
• Excess reserves stand at slightly over $1 trillion, roughly equal to 7% of average GDP over the 2007-2009

In the Winter of 2008, the Federal Reserve faced a difficult decision:

• The overnight funds rate on reserves, the base rate the Fed controls, was set at 1%, but the traded rate was 0.14%. So, as predicted, the Fed slashed its rate by 0.75 points and starting paying interest on excess reserves.
• Today, the Fed pays interest on excess reserves equal to its targeted funds rate 0.25%. However, the effective rate trades between 0.10% and 0.2% according to market data from the FT, pointing to continued slack in the system.

What to do:

• GDP for 2007 was barely over $14 trillion. In 2009, it was $14.1 trillion. Assuming the US grows at 3% per year, mid-2010 GDP would have been roughly over $15.1 trillion. The difference between potential output and current GDP is the amount of money parked at the Federal Reserve, earning 0.25%.
• Stopping the payment on excess reserves could be a boost to growth of the economy. Banks will have to find a home for this money. However, faced with the uncertainty of the current economy, and an economy facing deflation, banks may simply continue to keep those reserves parked at the Fed.
• The only major use of this income in the short term, would be a new round of stimulus. Highly controversial, yet effective according to a new paper by Mark Zandi of Moody’s and Alan Blinder of Princeton. Consumers are saving more, 6.2% of their disposable income, equal to ~$700 billion. This is roughly $450 billion more than during normal times. Fair to say, this money is being parked at the Fed in the form of excess reserves.
• Suspending interest payments on excess reserves would almost certainly bring the effective rate to zero. Using the Taylor Rule, the difference between 0.1 and 0.0 would add 0.2% increase in GDP given current CPI - not much.
• Yet, cash earning zero would have to find a home. Maybe then it would be possible to fund a second stimulus. Ideas for this stimulus would be as follows:

1. Replacing all municipal buses and taxi cabs with clean burning natural gas buses and taxis made in the USA.  This would have a significant impact for both the natural gas industry as well as domestic manufacturing.
2. Expanding high speed rail for both passenger and freight transport (moving more post and parcel service onto high speed rail). Key links would be Chicago to Detroit and the East Coast as well as continued east coast service from Boston all the way thru Charlotte and Atlanta.
3. Increasing port capacity for greater exporting ability in Houston, New Orleans, Virginia Beach, Philly, New York and the entire West Coast.
4. Increasing rail capacity in the Midwest to make manufacturing easier (and cheaper) to move to the coastal parts of the country.

To be sure, the investments outlined above would be 2-5 years in duration, shifting the excess reserves to the right on the yield curve where the current 10 year treasury yield stands at 2.91%. But infrastructure investments are incredibly productive. All of these outlined above would for sure produce more than 2.91% over ten years in returns. It’s a bet worth making and funding worth investing.

Four data points (from the Market Data section of the Financial Times) start the discussion:

1. Today, the US Dollar to Euro exchange rate is ~$1.29.
2. The one year (longest published out) Dollar Spot Forward is ~$1.29 as well
3. The ~ 1 Year US Treasury Yield is 2,99
4. The 10 Year Yield on a German bond is 2.75

Multiplying (1+.0299)^10 * 1.29 Divided by (1.0275)^10 = $1.32 to the Euro, suggesting the Euro is long term undervalued.

However, what about the following other Euro countries? Here are the following ten year yield and percentages of Euro Currency 2009 GDP:

• Austria - 3.13 (3%)
• Belgium - 3.36 (4%)
• Finland - 2.93 (2%)
• France  - 3.03 (22%)
• Germany - 2.75 (27%)
• Greece - 10.53 (3%)
• Ireland - 5.42 (2%)
• Italy - 3.99 (17%)
• Netherlands 2.94 (6%)
• Portugal 5.52 (2%)
• Spain 4.28 (12%)

By averaging the ten year yield based on the gdp of all Eurozone countries, we find the Eurozone 10 year yield is 3.57%

Multiplying (1+.0299)^10 * 1.29 Divided by (1.0357)^10 = $1.22 to the Euro, suggesting the Euro is long term overvalued. Adjusting this calculation for % of Public Debt to GDP, the value of the Euro drops to $1.21 to the Euro

What is the explanation?

Countries in crisis (such as Portugal, Spain, Greece and even Italy) have taken advantage of Eurozone financing for government financing. This purchasing has negated the need to tap domestic and foreign capital markets for purchases. This lack of foreign exchange has created a void for deciphering where the euro is truly in demand. This is further evidenced by an officer of BBVA’s notorious quote earlier this summer.

What this essentially means is that current account surplus countries such as Germany are forced to help out current account deficit countries such as Greece and Ireland. Yet the Eurozone has a current account deficit. If Germany and German banks are bailing out Greece and Ireland, countries such as China are only buying German bonds. This makes German sovereign bonds the “on the margin” security denominated in Euros sold and traded in foreign currency and not just in Euros.

The “marginally available” security is probably the major explanation why the Dollar Spot is valued closer to the Covered Interest Parity Calculation using the German 10 Year Bond than the composite of European Bonds.

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.

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.

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.

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.

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 November 3rd, I wrote that the market was already stating deflation in the US was on its way. TIP yields were priced way above treasury yields, even correcting for recent large capital flight into the US.

Today, the market reacted to the  price declines in the UK and the US for the month of October:

• For the US, prices declined by 1% for the month of October
• For the UK, October hosted the steepest drop in prices since 1997

Lesson one: even in illiquid times, its hard to bet against the market.

Here are a few reasons why it is not surprising to see price declines of this magnitude in either country.

• I would argue most importantly, both countries have witnessed massive home value declines. Essentially, every family in each country was forced to estimate their now reduced net worth (with great uncertainty) and reign in spending on everything from cars to consumer durables.

• Oil, which both countries import, has declined almost $100 a barrel in the last few months. The fact that oil has declined has two profound effects:

1. While the FED dismissed energy as part of core inflation, increases in energy increase the cost of goods produced and sold (including food), increasing prices throughout the economy. In turn, a decline in energy should result in a decline in all prices.
2. Increases in import prices put stress on the balance of accounts, forcing currency devaluation, which in turn increase prices in the short term. Therefore, a decline in imports (as oil has declined) should improve the current account balance, improve currency (as the dollar has strengthened) and reduce prices.

However, now the UK and the US are in two different positions.

• The UK has a base rate of 3%

• The US has a base rate of 1%

The UK therefore has greater room to maneuver. The US has all but exhausted its monetary toolkit to fight deflation and grow our economy. All but certain, the Fed will slash rates by 50 basis points this December, and perhaps provide guidance it will not increase rates anytime soon.  When Obama assumes office, the new administration can only (and must) invoke a massive fiscal stimulus to revive the economy, hopefully in the form of infrastructure spending and tax cuts.  Across the pond, The UK still has the ability to do both to fight deflation and revive its economy. Further, a decline in rates for the UK should further reduce the Pound, allowing the UK to help export its way out of this malaise. The US does not have this luxury.

While many in the US are against government spending, I hope they realize that as of now, we do not have a choice.

Hank Paulson is a graduate of Harvard Business School, my cross town rival. (I went to MIT Sloan).

As 60 minutes shadowed him prior to the Congressional Approval of his bill, he was a leader handling a crisis:

1. Keep calm
2. Keep the solution simple
3. Execute the simple solution

So he must have known using the Treasury Department to buy asset back securities would be challenging, painful, and timely.

Today, the Financial Times, the New York Times, and the Wall Street Journal are all reporting the Treasury Department is considering equity stakes in banks, rather than purchasing asset backed purchases.

This solution, proposed and scoped early last week in our Third Note, is simpler and more effective.

1. Take equity ownership,
2. Ease capital constraints,
3. Start working through this mess.

On Timing, Hank has no choice.

If a bank asked you for a debt investment of 10 years, would you say yes? At what rate? Most banks are having real problems rolling over their long term debt. Sans long term debt, banks must use short term LIBOR, crippling our working capital system.

Yesterday, US Overnight LIBOR closed at 5.375%, up 1.48% for the day.

Hank, it is time to hit the reset button.