Is It Time To Break Up The Big Banks?

There is a growing, bi-partisan movement on Capitol Hill to pass legislation to break up the big banks.  When was the last time that Democrats and Republicans worked in a bi-partisan fashion on anything?  But I digress. 

Former Federal Reserve Chairman Alan Greenspan said recently, “if push comes to shove… I would be in favor breaking up the banks.”  Conservative columnist George Will recently wrote a persuasive editorial urging conservatives to support legislation proposed by Ohio U.S. Senator Sherrod Brown (D) to break up the big banks.  Before we look at this proposed legislation, let’s look at the facts.

How many financial institutions are there in the U.S?  As of 2010, there were about 7,700 financial institutions with insured deposits from the Federal Deposit Insurance Corporation (FDIC).   

How are assets distributed among these 7,700 banks?  The top 12 banks currently hold 69 percent of the total assets of the banking industry.  Community banks, which total about 5,500, have about 12 percent of the banking industry’s assets. 

What are the problems associated with large financial institutions?

1. They are too big to fail.  We cannot allow them to fail because of the negative consequences to our economy and to the world’s banking community.  So this means that we socialize the losses (taxpayers pay the bill) but when they are profitable, as they are now, the banks are allowed to keep their full share of the profits.
2.  They are too big to manage and too complex to regulate.    The recent bank scandals – LIBOR manipulation, money laundering, robo-signing, the “London Whale” – prove the megabanks are out of control.  Though there are a lot of good things in Dodd-Frank, it can only do so much to regulate bad behavior in the banking industry.
3. They are given preferential treatment.  The 20 largest banks pay between 50 to 80 basis points less when borrowing from The Federal Reserve than what community banks must pay.  
4. They are too big to prosecute.  Attorney General Holder stated in recent Senate testimony that “some of these institutions are so large that it becomes difficult for us to prosecute them.”  So in essence, they are too big to jail.  To prove this fact, no one all Wall Street was found guilty on any charges stemming from the 2008 financial meltdown.

So what would the SAFE Banking Act, co-authored by Senator Brown and Senator David Vitter (R-La), do to solve these problems?

1. It would provide sensible limits on the amount of debt that a single financial institution could hold.  No bank could have more debt than 2% of U.S. GDP; and no investment bank could have non-deposit liabilities exceeding 3% of GDP. 
2.  Their funding would be required to come from more stable sources, with about $3 of deposits for every $1 in volatile non-deposit funding.  
3. Banks in excess of this limit would be given three years to comply by drawing up their own proposals to meet this requirement.

Which banks would be affected?  Only six banks would be broken up: JP Morgan Chase, Goldman Sachs, Bank of America, Morgan Stanley, Wells Fargo and Citigroup. 

Now that the economy is improving and there are no immediate crises at hand, we need our legislators to push this bill through Congress on a bi-partisan basis for the president’s signature.  This is something that all of us should want to have enacted.  This is good legislation.  Let’s do it!

Sources: Is Fed Signaling Stance on Bank Break-Ups?, by Kayla Tausche, CNBC.com, March 15, 2013; Senator Sherrod Brown explains why he wants to break up the big banks, by Ezra Klein, The Washington Post, March 9, 2013; Time to break up the big banks, by George F. Will, The Washington Post, February 8, 2013.

Are we experiencing a stock market bubble?

The Dow Jones Industrial Average closed today (March 8th) at another record all-time high of 14,397.07. On the surface this seems like great news.  At long last we are emerging from the Great Recession of 2008.  I read an article in today’s Oregonian which stated that with the recent rise in home prices and the robust increases in the stock market that most Americans have regained the net worth they lost five years ago due to the collapse of the economy.  Wouldn’t that be good news if it were true?  It makes me want to sing a round of “Happy Days Are Here Again.”  

The question that is on my mind, and a lot of like minded people is, “Are we experiencing a stock market bubble caused by The Fed’s quantitative easing policy?  Federal Reserve Chairman Ben Bernanke says emphatically “no.”  He recently told the Senate Banking Committee that he "does not see much evidence of an equity bubble." Yes, stocks are high he says, but that’s because The Fed’s recent policies, which have kept interest rates near zero since 2008, are working to spur spending. 

So let’s begin with the facts.  I think there are three possible reasons for the stock market surge:

• First of all the economy is not as weak as we have been led to believe.  We have seen modest growth in autos, housing and manufacturing activity.  Today’s employment report shows improvement in the private sector employment resulting in a downward tick in unemployment to 7.7%.  Not great but improving, nonetheless. 
• With The Fed’s policy of keeping interest rates at near zero is making it impossible to get an honest return on bonds, savings accounts, money market funds or CDs.  I believe investors are putting their money in equities because these other traditional forms of investment have been taken away from them.
• There is some evidence to suggest that investor confidence is surging because we have avoided the serious crises in Europe and the United States from imploding.  The euro zone crisis and the fiscal cliff crisis in the U.S. have worked their way out and investors feel more confident that we will continue to somehow muddle through. 

However when you look at the stock market fundamentals there is little justification for the recent rise in equities:

• Profit growth has been slowing.  The growth rate in the S&P 500 has slowed from 6.0% last year and is projected to be 1.2% the first quarter of this year. 
• The best long-term measure of value is the price-earnings ratio.  Currently the PE ratio is at 22.9 which is 39% above its long term average.  In other words stocks are significantly over priced.  An old rule of thumb is when investors buy assets at above average valuations they will suffer below average future returns.

It is my opinion that this bull market is not driven primarily by economic reality on the ground but by The Fed’s quantitative easing policy.  Fed Chairman Bernanke says that he plans to continue this policy for at least another two years which bodes well for the stock market for the foreseeable future.  In the short run I wouldn’t bet against The Fed Chairman.  But at some point when a new crisis emerges or an old one raises its ugly head then all bets are off.  

Sources: The Great Stock Market Rally, The Huffington Post by Jerry Jasinowski, March 8, 2013; Better than the alternatives, The Economist, March 9, 2013, Bernanke: There is no stock bubble, CNNMoney by Annalyn Kurtz, February 26, 2013.

John Mitchell’s Interest Rate Forecast

John Mitchell, a well respected economist, gave his economic update at the annual HFO Investor Roundtable event January 8^th.  It was another excellent presentation by Mr. Mitchell who has the uncanny ability of making economic forecasting interesting. 

To summarize Mr. Mitchell’s economic forecast, he believes we will continue to see an improving economy, albeit at a slow growth rate of about 2.0% annually.  Certainly this is nothing to be excited about but it’s far better than falling into recession.  

What I would like to focus my attention on today are Mr. Mitchell’s comments about where interest rates are heading over the foreseeable future.  So let’s first discuss what The Federal Reserve has been doing recently and then discuss what policies they intend to adopt going forward.     

·        From the standpoint of monetary policy, The Federal Reserve cannot push interest rates down any further.  Short term rates are near zero and they can’t go any lower than that.

·        The end of last month, The Fed’s Operation Twist was terminated.  This program manipulated the market by selling short term treasuries and purchasing long term treasuries which has resulted in driving down long term interest rates.

·        The Fed recently announced QE4.  Recall that quantitative easing is an unconventional monetary policy of buying financial assets from banks and private institutions thus injecting a quantity of money back into the economy for the purpose of stimulating economic activity.

Now let’s see what The Federal Reserve plans to do going forward.  QE4, as it is being implemented this time around, has two components: 1) the purchase of $45 billion of U.S. Treasuries a month with maturities in the 4 to 30 year range; and 2) the purchase of $40 billion a month of mortgage back securities.  Both types of purchases will keep long term interest rates artificially low. 

The Federal Reserve announced in December that they plan to keep interest rates exceptionally low as long as unemployment remains above 6.5% and inflation is no more than 2.5%.  Currently, the U.S. unemployment rate is 7.7%.  The buying of securities by The Fed is open ended until these two benchmarks are achieved.    

So the big question is: Do you think that the unemployment rate will decline significantly in 2013 or that there will be a jump in inflation this year in order for QE4 to be discontinued?  Not very likely is it?  As much as I would like to see unemployment fall below 6.5%, at the present pace of the economy we are likely two to four years away from that happening. 

Mr. Mitchell then posed a very troubling question to the audience: How will The Federal Reserve unwind QE4?  The Fed currently owns about $3 trillion in securities.  By the end of the year that number will be about $4 trillion.  Discontinuing QE4 will result in a significant “pop” in interest rates and selling the $4 trillion they currently own will further cause interest rates to rise.  Long term this looks like a gigantic problem with no easy solution.   

But back to the original question: Where can we anticipate interest rates to go this year?  It all depends on our economy.  There are two likely scenarios.

1.   If the economy continues at the current pace, then interest rates should stay where they are. 

2.   If the world economy begins to slow down at the end of this year due to the current recession in Europe and the economic slowdowns of other countries such as China, Japan and Brazil, then our economy will begin to slow down too.  If the U.S. economy were to show signs of a recession I believe The Federal Reserve will double down on its efforts to keep the economy going.  If true they would buy more securities which means interest rates would go down even lower than they are today.       

I believe there is no chance that rates will go up this year as long as QE4 is being implemented.  In fact I will go out on a limb and say I believe the second scenario is the more likely.  If true, then interest rates a year from now will be lower than they are today.   

Either scenario bodes well for commercial real estate.  Keeping interest rates low will continue the current trend of rising real estate values in the Pacific Northwest. 

John Mitchell's Economic Forecast - Is It Going to Stop?

I had the opportunity to hear John Mitchell’s economic forecast at the October 19th Commercial Association of Broker's breakfast meeting.  John always does an excellent job making a boring topic interesting.  There were no surprises in his presentation about the current economic situation, the gist of which was, the U.S. economy is growing, albeit at a slower rate than one would hope.

John began with a quick review of where we are:

• In the 4th year of economic expansion (hard to believe that's true but it is)
• 4.5 million jobs below our January 2008 peak
• 4.3 million jobs above our February 2010 trough
• 73 days until the Fiscal Cliff (read my previous post if you want a quick primer on the Fiscal Cliff)
• Globally experiencing economic weakness - Europe, Brazil, China, Russia, India are all either in recession or their economies are slowing down
• In the fourth year with short term interest rates at zero
• The Congressional Budget Office and the International Monetary Fund are both warning of a U.S. recession looming within the next several months

But I didn’t go to hear John Mitchell talk about our current economic situation. I went there to hear what he thinks will happen going forward. Accurately forecasting future economic trends splits the men from the boys, which reminds me of the Yogi Berra quote: “It’s tough to make predictions especially about the future.”

Not surprisingly, John Mitchell didn’t go out on a limb making any bold predictions about our economic future. Economists as a rule are not known for being risk takers. John Mitchell believes that our economy will continue to sputter along in the 2% growth range and that inflation will stay in check at about 2% for the foreseeable future as long as the Fiscal Cliff is handled responsibly.  

What was disconcerting to me was how negative his overall presentation was.  John by nature is an optimist.  He is always looking for a "silver lining." Normally if he says something pessimistic he tries to sugarcoat it with some positive news.  That was not the case this time.  My notes are filled with downbeat statistics.  The big three downers were:

• The economic recovery is growing at an historically slow rate when compared to all other economic expansions since WWII. 
• The Fiscal Cliff.  Congress and the president need to work together to avoid an economic crisis of their own making.  If not handled properly it will throw the U.S. economy into a recession.
• Monetary Policy.  The Federal Reserve is out solutions and nothing has worked.  Interest rates are at historic lows, Operation Twist, and Quantitative Easing have had only modest impact on the economy.  

When he got done, I had to fight the urge to give him a big hug and tell him things will get better. 

Whether that is true or not will depend in large part on who we elect in November.  I hold out no hope if President Obama is re-elected for another four years.  I'm not sure he even acknowledges that we have a serious debt crisis that will take us down the same path that Europe is traveling if we don't do something about it soon.  Mitt Romney talks a good game.  He at least says the right things but I'm skeptical he will have the courage to make the hard choices to get us back on track.  Is he a statesman or just another politican saying whatever is necessary to get himself elected?  I'm sure I've just offended both the Democrats and Republicans that read my blog.  Sorry.  I consider myself an equal opportunity offender.    

QE3 - To Infinity and Beyond!

The recent news from The Federal Reserve reminds me of a saying by Buzz Lightyear. You remember ol' Buzz, the toy astronaut, in the movie series Toy Story. Every time he lept from a piece of furniture, he would proclaim with great fanfare, "To infinity and beyond!!"

That's more or less what Ben Bernanke said recently and I might add with about the same enthusaism. The Fed will try a new round of quantitative easing to jump start the economy. And Mr. Bernanke implied there is no cut off to this third round. He'll do it as long as it takes to get the desired results. Hence, to infinity and beyond is a good interpretation of his policy.

My friend Kevin Geraci of Zions Bank wrote a well written article recently on this subject. I don't normally quote verbatim news articles but I thought his was deserving. So here goes:

 

Two weeks ago, the Federal Reserve announced its third round of quantitative easing, more commonly called QE3, whereby the Fed essentially prints money and then buys assets with it in order to add liquidity to the financial system and bring down interest rates.

 

The ultimate goal of this monetary policy tool is to spur economic growth and lower the unemployment rate—the same promise we got in QE1 and QE2.   Further, the Fed also announced that it is also changing its interest rate forecast and now sees the Fed funds rate remaining exceptionally low through mid-2015 (previously it was late 2014).

 

The announcement of QE3 is wearisome for many and for many reasons.  While the stimulative policies are temporary and artificial, the laws of macro-economics typically are not.  Asset prices have been artificially manipulated and do not reflect long-term economic reality. So what?

 

Two weeks ago, commodity prices rose again as investors sought to hedge themselves against a falling U.S. dollar.  Quantitative easing serves to dilute the money supply still more, and naturally the value of the money declines.  This may be good news if you are an exporting business, but the falling dollar will cause commodities to rise even higher, exactly what we do not need in a recovering economy as essential commodities like food and fuel get much more expensive.

 

The FOMC, of which Ben Bernanke is Chairman, now employs a staff of about 450, about half of whom are Ph.D. economists.  Perhaps that is the problem - the lack of common sense in the ‘monetary market place’.  Perhaps Bernanke should employ a few middle-class workers on his staff as a ‘reality barometer’ to see first hand what is working and what isn’t!

 

And now the Fed states that instead of purchasing customary Treasury Bonds, it is going to purchase large quantities of Agency Mortgages (Fannie, Freddie and Ginnie), up to $40 billion per month worth, in hopes of stabilizing the housing market and creating more jobs.  As if the Government debt situation isn’t bad enough, the Government will own huge pools of 30-year fixed rate agency mortgages that over time (certainly before they mature) will be at interest rates less than the Government’s own Fed funds rate.  Now that is a good investment!

 

Little has taken place in the economy here, and elsewhere in the world for that matter, as a result of QE 1, 2 and likely 3.  Meanwhile, our national debt now exceeds our Gross Domestic Product for the first time since WWII.  So when our creditors start feeling confident enough in their own economies to start cashing in their T-Bills for higher yielding investments, where does our Government get that money?  Or, when our Social Security Fund, the only Federal Budget item that is funded via dedicated funding sources, wants to cash in its Treasury Bonds to pay for your retirement or disability, can we pay them?

 

Is it time to ask the wise men at the FOMC what they're doing?!

 

Fact or Fiction: We're going down!

I just finished reading, Aftershock: Protect Yourself and Profit in the Next Global Financial Meltdown by David Wiedemer, Robert Wiedemer and Cindy Spitzer.  As you can imagine by the title of the book, the authors are not too bullish about our future.  Let me restate that: they are down right pessimistic about our chances of correcting our economic ship.  As far as they're concerned it's not going to happen. We're going down in flames and we're going to pull down the rest of the world with us.  

Now before you go and find a bridge to jump off of, the world will go on, a new economic order will eventually emerge from the ashes and the U.S. will likely lead the way again, this time a whole lot wiser as we learn from the mistakes of the past 30 years that set us on this course in the first place.  That's the gist of the book.  
The question that we need to ask ourselves is: How true are the premises presented in the book that lead to this conclusion?  Are these authors a bunch of nut jobs or do they have valid points? While I don't agree with some of their conclusions, I believe the overall framework that they present is both logical and intuitive. Let's see what you think as I outline the basic premises of their book.

The authors believe that beginning in the early 1980s, with the decision to run large government deficits, six co-linked bubbles have been growing bigger and bigger, each working to lift the others, all booming and supporting the U.S. economy.  A bubble is defined as an asset value that temporarily booms and eventually busts, based on changing investor psychology rather than underlying, fundamental economic drivers that are sustainable over time.  The six bubbles are:

1. The real estate bubble
2. The stock market bubble
3. The private debt bubble
4. The discretionary spending bubble
5. The dollar bubble
6. The government debt bubble

The first four of these bubbles began to burst in late 2008 and 2009 which rocked the U.S. and world economies.  It's kind of difficult to disagree with this premise with maybe the exception of the stock market.  Was the stock market crash of 2008 as a result of a bubble? The authors make a compelling case (which you'll have to read) that the stock market crash of 2008 was in fact a bubble that was not supportable by sound economics.  

The second major premise of the book is that while most people think the worst is over, the coming Aftershock will bring down all six bubbles in the next two to five years.  Whoa!  So what's the evidence to support their view.

The authors go on to explain that money, like all assets, is also affected by the law of supply and demand.  If there are too many dollars available their value falls.  In the past four years The Federal Reserve, in order to avoid a collapse of our economy, has increased the money supply through Quantitative Easing from $800 billion to $2.6 trillion.  This is an unprecedented increase in the money supply. The final bubble to pop is the government debt bubble.  Our national debt in that last four years has increased from $10 trillion to $16 trillion!  Both the dollar bubble and the U.S. government debt bubble have been pumped up to offset the other popping bubbles.  Both are on unsustainable paths and they too will pop bursting America's and the world's economy.  

As I mentioned earlier I don't agree with everything they say in this book.  My fundamental disagreement is in the inevitability of the last two bubbles popping.  If present trends continue, i.e., we continue to avoid making difficult decisions, then I absolutely agree that the dollar and government debt bubbles will pop as predicted.  I also believe that nothing will get done to solve our economic problems until there is a crisis.  

The good news is there is a crisis looming which should get our politicians' attention: Europe.  There is no solution to Europe's debt crisis.  None.  Anyone who thinks otherwise is living in "la la land." Europe's days are numbered.  When they falter, and they will, this catastrophic event should give our political leaders the impetus to make the necessary, painful decisions to keep us from following Europe over the precipice.  Just like the days immediately after 9/11 both political parties will come together for a short period of time.  As Rahm Immanuel once said, "You never want a serious crisis to go to waste."  Let's hope they take advantage of the collapse of Europe to right our economic ship so we can avoid following in their footsteps.    

Why Inflation Is Just Around the Corner

Thirty years have passed since we’ve had a significant bout of inflation in this country.  At the peak of this inflation battle my money market account earned 21 percent interest!  That was the good side of inflation.  The bad side of inflation was banks pretty much stopped lending and the only lending getting done was seller financed or other creative forms of hard money lending.

For the past 30 years we’ve seen interest rates slowly decline on commercial real estate from 12 percent to now 4 percent or less.  I believe the days of ever lower interest rates are coming to an end.  In fact, I believe the days of double digit inflation is inevitable and I believe it’s just around the corner.

But before I go further on what I believe is in store for us as a nation, let’s review what inflation is and what causes it.

What is inflation?

Inflation is an increase in the price of goods and services not due to growing demand or shrinking supply for those goods and services (which also affects price) but due instead to the dollar losing its buying power.
There is a difference between real price increases and inflation.  The price of oil could be going up because we are running out of easy-to-find oil, or demand has gone up because China’s rapidly growing economy is demanding more oil.  That’s not inflation; that’s a real price increase due to the forces of supply and demand.

What causes the dollar to lose buying power?

The value of money is affected by supply and demand.  If there are too many dollars available their value falls.  When the money supply is dramatically expanded in an economy with no or slow growth, as is happening today, the value of the dollar will eventually decline.  In short, too many dollars (too much supply), relative to the slow growth of the economy (too little demand), leads to the falling value of the dollar, a.k.a, inflation.  Therefore, real cause of inflation is increasing the money supply beyond what is needed to keep up with economic growth. 

What is causing the money supply to expand so rapidly?

The Federal Reserve in an attempt to rescue the economy began in early 2009 purchasing $2 trillion in U.S. mortgage and treasury bonds with printed money.  The technical term for these big bond purchases is “quantitative easing” or QE. Then in November 2010 the Fed began more bond purchases (QE2), adding an additional $600 billion to the nation’s money supply over the next year.  Again the goal of the money printing is to stimulate the economy back to health.

How much has the money supply increased in recent years?

In 2008, before QE, the U.S. money supply totaled $800 billion.  Today, the money supply is $2.6 trillion or more than triple what it was in 2008.  This is a stunningly large increase.  Nothing like this has ever occurred before in the United States.

Why aren’t we experiencing inflation now?

A paper written in 1999 by Ben Bernanke, the Fed chairman, et.al., examined past periods of inflation and determined there is about a two-year lag between increasing the money supply and the onset of inflation.  It can be delayed further if the Fed takes other actions to create more lag time, which I’m sure they are trying to do.  It can be delayed but it can’t be prevented. 

Exactly when will inflation begin?

Good question.  The truth is no one knows when it will begin in earnest.  The authors of Aftershock: Protect Yourself and Profit in the Next Global Financial Meltdown believe that significant inflation will begin in the 2013-2015 range.

What does this mean for commercial real estate?

We live in uncertain times.  Many factors lie outside of our control to influence. As property owners refinancing our real estate is one area of our lives that we can be proactive and take control of the situation by locking in low interest rate, long-term financing.  Those who do will be the big winners. 

Source: Aftershock: Protect Yourself and Profit in the Next Global Financial Meltdown by David Wiedemer, PhD, Robert Wiedemer & Cindy Spitzer; John Wiley & Sons, Inc., 2011.

Another Questionable Decision by The Federal Reserve

The Federal Reserve last Thursday released a proposal that would implement a global agreement known as Basel III. This agreement is a regulatory standard that proposes minimum capital requirements and liquidity standards for all financial institutions worldwide.

I know what you’re thinking as I was thinking it too: I’m tired of reading another boring article on banking regulations. But I would encourage you not to delete this blog post before you get a “view from 35,000 feet” on how Basel III is going to impact the commercial real estate industry. It could have an enormous adverse impact on our industry if not implemented gradually.

From our perspective the most egregious new implementation being proposed by Basel III is assigning a higher risk weight to commercial real estate loans of 150%, up from a current risk weight of 100%. How does that affect the bank? The more risk, the more capital that’s required by financial institutions to have on hand as a buffer. So the more they lend on commercial real estate the higher their capital requirement. If they lend on other assets, home loans or businesses for example, they will not be required to hold as much in reserve.

So what do you think the banks are going to do when this new rule is fully implemented? Do you think they will lend more or less on commercial real estate? Of course, the tendency will be to lend less. And how do you think in real terms that will be done? I think there will be fewer banks lending on commercial real estate and those that do will find a plethora of ways to make it that much more difficult to get a loan approved and closed (as if we need more banking regulations to slow down the loan approval process).

This isn’t me just “crying wolf.” Fitch Ratings estimated last week that the world’s 29 largest banks will need to raise another $566 billion by the end of 2018 to meet these new international liquidity requirements against risk. Where is that going to come from?

I wonder why they consider commercial real estate so risky? The Great Recession was brought about by a housing bubble and lax underwriting standards for qualifying borrowers of home loans, not because of excesses in the commercial real estate industry. So why pick on us? Why make commercial real estate the scapegoat? The Federal Reserve needs to think this through and figure out what the ramifications are to our economy if this is fully implemented. Basel III ultimately means less lending on commercial real estate which means a slower economy which means fewer people being employed.

I’m all in favor of reforming the banking industry (remember I’m in favor of Dodd Frank) but increasing the risk weight for commercial real estate may be over the top. There’s got to be someone on The Federal Reserve Board of Governors who has enough common sense to understand this and has the courage of his convictions to push back. Don’t you think?

Sources: Basel III, Wikipedia; Fitch Ratings: World's Biggest Banks May Need To Raise $566 to Comply With New International Rules, Huffington Post, June 7, 2012; Fed ups capital buffer for commercial real estate, Market Watch, The Wall Street Journal, June 7, 2012; Federal Reserve unveils Basel III bank capital proposal, The Economic Times, June 8, 2012.
 
 
 

What exactiy did The Fed do?

Last week the Dow Jones Industrial Average soared almost 500 points (4.2%) on the news that The Federal Reserve in a coordinated effort with five other central banks of the world came to the rescue of European banks. Specifically, The Fed’s action effectively gives these central banks access to a massive pool of new U.S. dollars that they can borrow at a very low rate of 0.5% to fund their banking sectors. Why should this action be viewed with euphoria by the world's stock markets?

To better understand what is going on you need to know why The Fed took this action. For European banks to lend money they have traditionally borrowed dollars from other banks, money market funds and institutional investors. As the European debt crisis has deepened, these lending sources have slowly pulled back because Europe’s banks are holding ever larger amounts of sovereign debt that is becoming increasingly more likely it will not get paid back.

Since May, U.S. money market funds have reduced their loans to European banks by 42 percent reports the Fitch rating agency. If we could know what the other lending sources for European banks were doing we would likely see the same response. Prudent lending sources seeing the increasing risk of sovereign debt are unwilling to risk their own money by lending it to the European banks. This is just plain common sense. You would do the exact same thing. Therefore the reason The Fed acted as it did last week is because the European banks were starting to experience a liquidity crunch.

It is the equivalent to what happened to Washington Mutual a few years ago. Recall what brought down WaMu was bank customers losing confidence in the long term viability of the bank quietly, but ever so quickly withdrawing their deposits. There was a run on the bank. In the period of a few weeks, WaMu went from being healthy to insolvent. The exact same thing is happening right now to European banks. The only difference is that it is happening across all the major banks in Europe, not just one particular lender like Washington Mutual. So I ask you? Is this something to be euphoric about? Does this justify a 500 point increase in the Dow? Only if you think bad news is good news.

We should be very concerned with what just happened and here’s why:

1. This did nothing to solve the European debt crisis. All it did was to delay the outcome.

2. The Federal Reserve has now become the lender of last resort. In other words when a European bank defaults, which will happen, we the American public will be picking up the tab.

How does that make you feel?  Euphoric?


Sources: What exactly did the Fed do?, by Robert J. Samuelson, The Oregonian, December 2, 2011; Fed Action in Europe Underscores Dollar Primacy, STRATFOR, November 30, 2011.

How Bill Gross Got It All Wrong

Earlier this year Bill Gross, the head of bond giant PIMCO, announced in grand fashion that he was getting out of U.S. Treasuries. His reasoning was quite rational: The end of the Fed's quantitative easing program, which ended in June, would be bad for bonds. Prices would fall causing yields (or interest rates) to rise. This would happen because the Fed was the number one buyer of U.S. debt. Without the Fed buying bonds one of two things would have to happen to prevent yields from rising:

1. Some other country would have to step in to buy the Fed's volume of U.S. Treasuries which was highly unlikely, or
2. The U.S. government would have to significantly moderate their borrowing to shrink the volume of U.S. Treasuries being sold on the market. At the present time for every $1 spent by the federal government about 40 cents of that amount is borrowed.

So what do you think are the chances of either #1 or #2 happening? Not likely is it? Looking at it from this perspective, it seemed quite unlikely that another country could purchase the enormous quantity of bonds that the Fed had been buying over the last two years. And it also seemed unlikely that the federal government would reduce its need to borrower.

This past week people were crowing about how Bill Gross got it all wrong and how he lost a lot of money for his bond fund investors. He even admitted sheepishly that it had been a "mistake" to get out of U.S. treasuries. Since Mr. Gross’s announcement in March the 10 year treasury rate has plummeted from 3.46% to 2.02% (Sep 2nd). So how does someone of Mr. Gross's caliber get it wrong? What did he miss?

Back in March when Mr. Gross made his announcement there was no way for anyone to predict:

1. That the sovereign debt crisis in Europe would reach critical mass this year. European leaders had been successful over the years in “kicking the can down the road” and it seemed likely this year would be no different. Wrong!
2. What the impact of the sovereign debt crisis would have on the U.S. treasury market. Fear of a default of sovereign debt by Greece and then by Italy has caused a panic among Europeans. And when panic ensues, investors take their money out of risky investments promising a return on their money and instead invest in less risky investments, in this case U.S. treasuries, where they focus on getting a return of their money.

What has happened is the law of supply and demand has kicked in. Concerned European investors have dramatically increased the demand for U.S. treasuries while the supply has stayed the same. When that happens, yields decline. It’s really that simple.

But the big question is, “How does this affect those of us in the commercial real estate market?” We are currently seeing historically low interest rates.  A lower interest rate means a lower mortgage payment which means better cash flows after debt service. If you own commercial real estate now is the time to lock in long term fixed rate financing.

I know I sound like the boy who cried wolf one too many times but some day we are all going to wake up and the world will be different. Some unpredictable catastrophic event will have occurred (a run on U.S. banks perhaps) causing interest rates to skyrocket and when that happens those who had the foresight to lock in the low rates will be the big winners.

Source: Bill Gross and the Case for Buy Low and Hold, Morgan Housel, The Motley Fool, August 31, 2011.

Fed Scorecard: Where QE Worked and Where It Failed

Quantitative Easing, which ended last Thursday, has had its successes and failures.  But before we look at the outcomes of QE let's quickly review what it is.

The term Quantitative Easing (QE) describes a form of monetary policy used by The Federal Reserve to increase the supply of money in an economy where interest rates are at or close to zero.  The Fed does this by first crediting its own account with money it has created ex nihilo ("out of nothing") or some would say, by "printing money."  It then purchases financial assets, including government bonds, from banks and other financial institutions.  The purchases give banks the excess reserves required for them to create new money.  The increase in the money supply thus stimulates the economy.  That's the theory at least.  Let's see how well it worked.

Where it Worked

1. The stock market benefitted.  Since last August when Fed Chairman Ben Bernanke announced QE2 the major stock indexes have increased between 20 to 29 percent.
2. Commodity prices climbed.  When a currency is debased, it takes more dollars to buy the same product.  Commodities such as oil, precious metals, farm products, etc have benefitted.
3. U.S. exports rose.  Cheap dollars when compared to other world currencies makes our exports that much cheaper, increasing the demand for our exports.
4. It reduced our chances for deflation.  By pumping enough liquidity into the markets we have for the time being avoided the harmful effects of deflation (far worse than inflation). 
5. It created a "Wealth Effect" for some.  If you invested in the stock market, or commodities during this time chances are you did quite well.

Where It Failed

1. Housing is broken.  Bernanke assumed that lower mortgage rates would have a positive influence on the housing market.  That has not happened.
2. Jobs market is broken too.  QE2 was supposed to spur spending, which would increase demand resulting in more jobs.  This hasn't happened.
3. Inflation may not be temporary.  Bernanke called food and energy prices "transitory" and will likely reverse.  This doesn't appear to be happening.  Inflation is currently 3.6% and trending upward.
4. Dollar's potential destruction.  There is a fine line, which may have been crossed, between stimulating the economy with cheaper dollars and ruining the currency.  This is my greatest concern.
5. Interest rates will eventually go higher.  They have to.  Rates are unnaturally low.  If the U.S. continues to borrow debt at the current pace, who will buy it once The Fed is no longer purchasing it?  In order to get sell our debt, rates will have to rise, maybe dramatically in order to attract a new buyer.  

In hindsight, it's easy to see that Quantitative Easing did not accomplish the two most important things it was supposed to do: 1) correct our housing crisis; and 2) get our economy moving in any substantial fashion.  

So where do we go from here?  What other means will be employed to get our economy going again?  Is there anything that can be done?  From my perspective, neither political party has had the political will to outline a realistic plan to get our economy moving in the right direction.  Leadership is the key but no one has yet to act like a statesmen instead of just another politician pointing fingers.  No one has yet shown a willingness to yield a little on one of their pet positions in order to achieve a benefit for the greater good.  Until that happens we will have more of the same. 

Sources: Yahoo.com, CNBC, Fed Scorecard: Five Ways QE2 Worked-And Where It Failed, June 30, 2011; Quantitative Easing by Wikipedia.

Exposing the Soft Underbelly of the Beast

For those of us who believe the Federal Reserve, Wall Street and the major financial institutions in this country wield too much power, something recently happened that has me baffled. 

In March the US Securities and Exchange Commission requested a few of the regional banks to clarify their loan modification policies, what we call in the business "extend and pretend."  Last month the Financial Accounting Standards Board (better known as FASB) also got into the act by issuing new accounting guidelines for "troubled debt restructurings" (TDRs).

On the surface the new accounting guidelines for troubled assets seems quite reasonable.  FASB wants to standardize the definition of what constitutes a TDR so all financial institutions are operating under the same rules.  Right now that isn't happening.  In order to determine if the restructuring is a TDR, a lender must separately conclude that both the borrower is experiencing financial difficulties and the restructuring constitutes a concession.

Beginning June 15th lenders must re-examine their restructured debt to determine how much of it qualifies to be a TDR.  If so, the lender must classify it as such.  The end result is that for the very first time we will see how much of a lender's loan portfolio is deemed "troubled."  At the present time, lending institutions have been able to hide their TDRs with the hope that one day the market will turn around and the loans will be refinanced at market rates and terms, or better yet paid off in full. 

The new accounting rules could have enormous implications, most of which fall in the range between bad and catastrophic.  At the very least the number of loans classified as troubled debt will rise dramatically throughout the banking industry.  But the big question is, "Will the general public's confidence in a bank's solvency be adversely affected?"  Once the cat is out of the bag will the stronger financial institutions be reluctant to transact business with their weaker brothers?

Which leads me back to my original thought: Why did the SEC and the FASB do this?  If you believe like I do (most days) that the Federal Reserve, Wall Street and the major financial institutions wield way too much power, why would they allow these new TDR accounting guidelines to be implemented?  This is not in their best interests.  The change in these accounting rules has the potential of exposing the truth that they desperately want to keep hidden from the public - most banks are hopelessly insolvent.  This only helps to expose their true predicament.

The huge bank bailouts by both the Bush and Obama administrations, the extend and pretend lending policies of the banks, and the historically low interest rates by the Federal Reserve have all been implemented to directly benefit the financial institutions of this country.  So why are they now exposing the soft underbelly of the beast?  If you have an explanation, I'd like to hear it.

Sources: The Extend and Pretend Expose' - coming to a bank near you, ft.com/alphaville by Tracy Halloway, May 20, 2011; More Transparency Coming to Hidden Costs of 'Extend and Pretend' Strategies, CoStar Group by Mark Heschmeyer, May 18, 2011. 

What Impact Will Inflation Have on Commercial Real Estate?

After decades of little or no inflation there is mounting evidence that the Federal Reserve's Quantatitive Easing program is beginning to take its toll on the value of the dollar.  Shown below are some of these indicators:

• The Producer Price Index (PPI), which measures average changes in prices received by domestic producers for their output, is up 5.6% for the twelve months ending February 2011.
• Commodity prices are rising in relation to the dollar.  The price of gold hit an all time high earlier this week before settling down a bit.  Silver prices continue to soar hitting a 31 year high.  So far this year silver has gained 33% in value.
• A recent Deloitte Consulting poll indicated that 74% of those polled believe their spending will slow due to rising prices they are currently experiencing.

So what impact will inflation have on commercial real estate?  In the short-term the real question is what impact will the threat of inflation have on the Federal Reserve raising interest rates?  An increase in the federal funds rate would ease the concerns of those who fear inflation but it would likely have a detrimental impact on the fragile U.S. economy which is just beginning to show signs of recovery.  It's a delicate balance between these two policy positions.

In the long run, modest inflation would be a great benefit to commercial real estate, as long as it happens gradually so that the market can make the necessary adjustments along the way.  Real estate over the long run has been an excellent inflation hedge and it should be the same this time around too.  Over time, with modest inflation those commercial real estate investors who are currently upside down on their investment portfolio could gradually become whole again. 

My greatest fear is what happens in June when the Federal Reserve ends its own bond purchase program known as quantitative easing.  Who will fill the gap in buying U.S. Treasuries?  If no one steps in to the fill the void what will happen to interest rates?  Doesn't the law of supply and demand require that interest rates have to increase?  And more importantly how quickly will they rise and how dramatically?

Those are the questions that are currently being debated.  Surprisingly there is no clear consensus among the pundits.  We'll have to watch and see.  Stay tuned.  It's going to be fascinating to watch! 

Sources: PIMCO bets against U.S. government debt, Reuters, April 11, 2011; Don't Believe the Inflation Fear-Mongers, The Mark, April 12, 2011; Inflation Not a Threat? Most Consumers Aren't So Sure; CNBC.com, April 12, 2011; Gold Price Sinks After Hitting Ne High at $1,478, Gold Alert, April 11, 2011; Producer Price Indexes - February 2011, Bureau of Labor Statistics, March 16, 2011.

Bill Gross Thumbs Nose at Bond Market

Last week Bill Gross, who runs the world's largest bond fund at Pacific Investment Management Co., sold all government related U.S. debt from PIMCO's $237 billion Total Return Fund.  You may be thinking, "Why is this tidbit of news important to us?"  Good question.  When someone who is as knowledgeable about the bond market as Mr. Gross decides to get out of U.S. bonds there's a good chance that something signficant is about to happen.  Gross is betting that the discontinuation of the Federal Reserve's Quantitative Easing program (QE2) in June will have a negative overall impact on the bond market. 

Let's back up for a minute and explain some things.  QE2 is the Federal Reserve program of buying U.S. government debt instruments for the purpose of stimulating the economy.  In a period of only 28 months the Federal Reserve has become the largest owner of U.S. Treasury Bonds ($972 billion as of December) surpassing both China and Japan who took decades to accumulate their bond holdings.  Yesterday, Mr. Bernanke, Chairman of the Federal Reserve confirmed that the Fed will discontinue QE2 as planned by the end of June.

Bill Gross wonders when the Fed stops buying bonds who will take their place?  The Federal Reserve is currently buying $75 billion in U.S. bonds a month.  That's a huge amount.  So what will be the impact when the Fed stops buying?  It all goes back to the law of supply and demand.  If the supply of U.S. treasuries remains the same but the #1 buyer of bonds is no longer buying, in order to get others to absorb the excess supply the market will demand a higher rate of return.  It's as simple as that.  Gross believes that the current interest rate on 10 year treasuries is at least 100 basis points below the historical average.

If Mr. Gross is correct the logical result will be a significant rise in interest rates and it should happen before the end of this year.  If true this could have a dramatic impact on the commercial real estate market.  Rising rates would require a re-adjustment in cap rates upward to offset the decline in investment returns due to higher interest rates.   

Years ago there was a TV ad by investment banking firm E.F. Hutton.  The ad shows an E.F. Hutton fiancial advisor about to give confidential investment advice to his client in a crowded, noisy room.  Before the advisor speaks the crowd stops talking and leans their ear to hear what he has to say.  The ad ends with the slogan, "When E.F. Hutton speaks people listen."  Mr. Gross has just spoken and his actions speak loud and clear.  Are we wise enough to follow his lead is the only question?  
_________________________________________________

On a totally different note, treasury rates have plunged in the last few days.  The 10 Year Treasury rate at this moment is 3.20%, down 55 basis points since January.  On the surface this flies in the face of what is being predicted by Mr. Gross.  In reality this substantial dip in rates is being caused by the crisis in Japan.  Japan's stock market, has plunged 16% in the last couple of days and investors are taking their money out of their stock market and putting it into the safest investment they know: U.S. Treasurys.  How ironic.   

Sources: Gross Sees Trouble Ahead for Treasurys, The Oregonian, March 15, 2011; Pimco's Bet Against Treasurys Not Working (So Far), Wall Street Journal, March 15, 2011; Federal Reserve Enters Final Lap of Easing Policy, National Journal by Clifford Marks, March 15, 2011. 

What’s Going On With Interest Rates?

by Doug Marshall, CCIM
Market Assessment

Over the past 60 days, the yields on 10-year Treasury notes have increased from 2.41% on October 8th to 3.53% as of December 15th, an increase of 1.12%.

What's going on?

Let's begin with a US Bonds 101 class. The 10-year Treasury note has become the security most frequently quoted when discussing the performance of the U.S. government bond market and is used to convey the market's take on longer-term macroeconomic expectations.

All of the marketable Treasury securities are very liquid and are heavily traded on the secondary market. The treasury yield expresses the relationship between the face value of the security and the amount of return the investor receives.

If there are more investors selling bonds then those who are buying bonds, the value of the bond declines (the law of supply and demand). A reduced price on the bond results in an increase in the yield or return on the bond.

Another name for “treasury yield” is “interest rate” which those of us in commercial real estate follow very closely. When US Treasury rates jump up significantly, like they have since early October, it means that investors are dumping their bonds in huge quantities. I can’t recall the last time I’ve seen interest rates jump so dramatically over such a short period of time.

So the $64,000 question is, “Why are bond holders selling off their bonds?” I have surfed the web for an answer to this question and unfortunately there is no agreement among the experts.

Depending on who you like to read there are a variety of answers. But being fearless and little bit stupid I am going to give you my opinion (take it for what it’s worth).

But before I give you my assessment of the situation let me muddy the waters a bit with some conflicting information.

Data released by the Treasury Department yesterday indicated that the Federal Reserve, China and Japan have recently been on a U.S. bond buying binge. The Fed is now owns $972 billion in Treasury holdings which surpasses China’s $906 billion (now the 2nd largest hold of U.S. treasuries).

And with more Quantitative Easing 2 purchases on the horizon it is highly probable that this lead will be greatly extended.

At the very same time, the debt crisis in Europe with what has happened in Greece and Ireland is continuing. Adding to the problem, on Tuesday Moody’s downgraded Spain’s sovereign debt causing further turmoil in the bond market. There is a very real debt crisis going on in Europe which is resulting in European investors transferring their wealth into (you guessed it) U.S. treasuries.

So in recent weeks bond purchases have been exceptionally strong by the major holders of U.S. debt and by the Europeans concerned with their own debt crisis but not nearly enough to offset all the little guys out there who own bonds and who are running scared.

Why are they running scared? There are two reasons that I think make the most sense

1. The Fed’s policy of QE2 is not working as planned. The printing of money by the U.S. Treasury and the purchase of these bonds by The Fed is perceived by the holders of bonds to be inflationary which makes their modest fixed yields less desirable if inflation is going to come roaring back
2. The other issue spooking bondholders that’s surfaced recently is the possible agreement by the Obama administration and Congress about extending the Bush era tax rates for another two years.
   

The compromise between the White House and Republicans included extending employment benefits for another 13 months which combined with extending the existing tax rates will increase the national debt by another trillion dollars. This means the U.S. Treasury will need to issue more bonds to cover the debt.

That being said, I believe that Ben Bernanke will do everything in his power to calm the bond market. What tricks he still has in his bag is anyone’s guess but he will do whatever he can to avoid runaway inflation.

Stay tuned. It’s beginning to get interesting.

Sources:
Fed Surpasses China in Treasury Binge, The Street by Eric Rosenbaum, December 15, 2010;
United States Treasury Securities, Wikipedia;
Bond Prices Fall Sharply after Federal Reserve Says It Will Continue to Boost Economy, The Associated Press, December 14, 2010.

What the heck is Quantitative Easing?

Doug Marshall, CCIM
Market Assessment

If you’ve listened to the news or read a newspaper in recent weeks there is a new buzz phrase being bandied about: Quantitative Easing. So what is it?

The term Quantitative Easing (QE) describes a form of monetary policy used by The Federal Reserve to increase the supply of money in an economy when the bank interest rate, discount rate and/or interbank interest rate are either at, or close to, zero.

The Federal Reserve does this by first crediting its own account with money it has created ex nihilo ("out of nothing") or some would say, by “printing money.” It then purchases financial assets, including government bonds and corporate bonds, from banks and other financial institutions in a process referred to as open market operations.

The purchases, by way of account deposits, give banks the excess reserves required for them to create new money by the process of deposit multiplication from increased lending in the fractional reserve banking system. The increase in the money supply thus stimulates the economy.

What is the purpose of Quantitative Easing?

The Federal Reserve has been given two mandates:

1. It is charged with ensuring full employment in the United States; and,

2. It is also charged with ensuring price stability. Inflation, in recent months, as measured by the CPI (Consumer Price Index), has declined to almost zero which is well below its target of two percent annually.

The Fed hopes that QE will stimulate the economy and thereby ease unemployment.

The Fed also hopes QE will bring the U.S. closer to its stated long-term inflation target.

The primary risk of QE is that it can spark inflation greater than desired or even hyperinflation. Or it could have no impact whatsoever.

Ben Bernanke, Chairman of the Federal Reserve, may be the “smartest guy in the room” but when he’s tweaking the largest economy in the world it is near impossible to really know what the impact The Fed policies will have on the economy.

What has been the impact of Quantitative Easing so far?

The first round of Quantitative Easing took place at the height of the financial crisis in late 2008 and early 2009. What impact did QE have on the economy and interest rates? Good question. I’m not sure anyone knows for sure.

Just recently the Federal Open Market Committee announced another round of Quantitative Easing called QE2. The Fed plans to purchase over $600 billion of long-dated Treasury securities over a period ending in June 2011.

Economists are debating what impact QE2 will have on interest rates. Ted Jones, PhD, Chief Economist for Stewart Title, says it has already significantly increased interest rates and uses the following table to support his position.

The table details the changes in constant-maturity Treasury rates since August 1, 2010. While rates are still comparably low, they have risen significantly in recent weeks.

As noted below in the table three-year Treasury yields are up 80 percent from the low just two weeks ago while two-year notes are up 60 percent. Even the 30-year Treasury yield has jumped 24+ percent since the end of August.

As convincing as this table is in supporting Dr. Jones’s opinion, I don’t think anyone can know for sure if the recent rise in interest rates can be directly attributed to the announced purchase of $600 billion of treasury securities over the next several months.

It seems to be too sharp of a rise in rates and it happened too quickly after The Fed announcement to be attributed to QE2.

But then again, who am I to disagree with such a distinguished and well qualified expert? We should know though in the next few months whether Dr. Jones is right or not. Let’s hope for all our sakes he’s not.

Sources:
Quantitative Easing by Wikipedia;
Does Quantitative Easing Work in Boosting the Real Ecomony? by Edward Harrison, November 4, 2010;
'Quantitative Easing': What Does It Really Mean for Investors?, Jeff Cox, CNBC.com, August 23, 2010;
Quantitative Easing Already Goosing Interest Rates, Ted Jones, Jones on Real Estate blog, November 14, 2010.