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.

Why a Greek Default is Important to Us

I know that if I emphasize too strongly what is happening in Greece I will be accused of being another Chicken Little proclaiming that “the sky is falling.” But reality is that a default by Greece on its debt obligations will likely have a serious adverse impact on us in the United States. But before I explain why let me back up a bit and give you a brief overview of what’s going on.

The Greek sovereign debt crisis has grown to the point that it is no longer a question of if Greece will default on its debt it’s now only a matter of when. It’s going to happen. Last week Standard & Poors lowered the country’s debt rating to triple C – its worst rating for any country in the world. The Greek government is teetering on collapse as massive demonstrations express their rage and frustration in the streets.

A survey indicated that 85 percent of all Greeks would rather default on their country’s debt than institute the severe austerity measures that are being proposed for a temporary bailout. And make no mistake it is a temporary bailout. Barring an absolute miracle any bailout will only delay the inevitable. They have already tried “kicking the can down the road” too many times and at some point they will have to pay the piper.

There are three ways a default by Greece on their debt will affect us:

1. A small portion of their debt is borrowed from U.S. banks – $10 billion or about 5% of their total debt. It’s not pocket change but that amount is not a serious exposure to their debt. That can be absorbed by our banks.

2. However, U.S. banks through credit defaults swaps have indirect exposure to 56% of the total Greek debt. This represents $116 billion of the total $206 billion that Greece owes. That’s huge! Simply put, a credit default swap is default insurance. What has happened is European banks have lent money to Greece but insured their Greek loans with default insurance from U.S. banks.

So the big question is, which no one has an answer for, “Will the Greeks be able to restructure their debt (negotiate a lower interest rate, maybe a forgiveness on some of the debt, etc.) or will it be a complete default?” If it is a restructuring of debt (kind of a “soft landing”) the European banks will absorb the losses. It will not likely trigger the default insurance.  If it is a complete default, then it is likely that the American banks’ credit default swaps will take the hit. And because most of those American banks who issued the credit default swaps are “too big to fail” guess who will be footing the bill?

3. As tight as credit has been over the past three years, it’s going to get even tighter if $100+ billion is taken out of U.S. banks to pay off the credit default swaps on the defaulting European bank loans to Greece.  That money would better served lending to worthy businesses and individuals in the U.S.  That’s the real killer concern.

Here’s my thinking on this situation:

1. Banks are hoarding cash. They are reluctant to lend to businesses, to consumers and on commercial real estate which would help get this economy going again. The potential default by Greece and others – Portugal, Ireland, and Italy are next in line – will only make matters worse if American banks are picking up the tab through credit default swaps.

2. Congress needs to enact legislation regarding credit default swaps that either bans this financial product or greatly reduces the American taxpayers’ risk if something goes horribly wrong.

3. Finally, it’s time to get tough on banks that make stupid investment decisions. The federal government should not have to provide bailout money to keep these banks solvent. Let them fail!

Sources: Time to Get Outraged, Thoughts from the Frontline by John Mauldin, June 10, 2011; Greek Debt Tsunami Could Reach U.S. Shores, MSNBC.com by John W. Schoen, June 16, 2011; Greek Crisis May Put California Bank in Play, The Street, by Dan Freed, June 16, 2011; Global Markets Shaken by Greek Debt Crisis, AlJazeera.net, June 16, 2011.

Oregon Economy Shows Impressive Growth

Tom Potiowsky, the Oregon State Economist, revealed the latest economic news at the June 1st Oregon/SW Washington CCIM Chapter meeting, most of which was quite positive.  Shown below are the highlights:

• Oregon job growth surged in the first quarter of 2011 rising at an annualized growth rate of 5.2 percent.  This is the third strongest quarterly job growth since 1990.  On a year-over-year basis, job growth is up 1.8 percent, the best since the first quarter of 2007.
• The unemployment rate has slowly edged down to 9.6 percent.  This is a full two percentage points below the May 2009 unemployment rate peak of 11.6 percent.
• For the last six months, job gains have been averaging over 4,500 jobs per month.  Oregon has the 7th fastest job growth year-over-year for March among the 50 states.
• Job gains in the first quarter were broad based with virtually all sectors seeing strong growth.  The exceptions to this trend were the wood products industry, and state and local governments.
• Personal income growth increased 3.3 percent in the 4th quarter of 2010.
• The declining value of the U.S. dollar is helping those businesses dependent on exporting their products overseas.  Oregon exports are up a whopping 18.6 percent over the previous year but much of this increase has to do with the abysmal performance from the previous year more than a spectacular increase in 2011.

Some potential concerns or "economic headwinds" as Mr. Potiowsky called them are:

• The federal government needs to get its financial house in order but it can't do it cold turkey.  Substantial cuts in spending could result in weakening an already fragile recovery.
• State and local governments are also in bad shape and represent between 10 and 15 percent of the overall economy.  Forty four states and the District of Columbia are projecting combined budget shortfalls of $125 billion for fiscal year 2012.  How they muddle through will need to be handled carefully to avoid harming the recovery.
• The housing sector continues to languish.  The recent Case-Shiller report indicated a 7.6 percent decline in year-over-year house prices in the Portland metropolitan area.  This will likely continue until the majority of foreclosures have worked their way through the system.
• If the credit crunch does not continue easing, commercial real estate may be even slower to recover than anticipated.  Credit markets are easing, but consumers and businesses still have difficulty getting loans.
• If gasoline prices continue taking up a greater portion of household budgets this will inevitably reduce consumer spending for other goods and services.

Even so, the job growth among a number of employment sectors in the first quarter of 2011 is nothing short of impressive.  The recovery is happening but with a few cautionary signals.  All in all, the economy is certainly looking better than it has for the past 3 years.  Let's hope it continues well into the future.

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. 

Retail Is Coming Back Nicely

In my last post I showed the first quarter sales results by property type for our region.  Not surprisingly, 42% of all sales for the quarter were apartments.  What was surprising was the strong showing from retail: 29% of all sales in the first quarter.  So I thought this deserved additional investigating.

The CoStar Group recently had a webinar on the U.S. retail market.  The bottom line of their presentation - retail is coming back nicely.  Shown below are two charts that support their thinking:

As you can see from the chart retail has had 9 consecutive months of positive sales volume (people are buying more) and has been averaging about 6% annual growth since September of 2010. 

Absorption of retail space is also improving nationally as shown in the chart below:

After two negative quarters of negative absorption, we've now experienced 7 consecutive quarters of positive net absorption.  During this time period 80 million SF of retail space has been absorbed. 

Other interesting tidbits from the CoStar webinar were:

• Job creation, which spurs retail sales, has been positive for the past 5 consecutive quarters.
• Construction of new retail space has been almost nothing for 2010 and is projected to continue that way through 2011, which bodes well for further net absorption of retail space through the rest of this year.
• Sales of distressed retails sales is moderating.  Distressed retail sales peaked at 21% of all sales during the 2nd quarter of 2010.  During the first quarter of this year, distressed retail sales were estimated at 17% of all sales.
• Cap rates for retail properties have compressed significantly.  Retail cap rates peaked at 8.5% in the 2nd quarter of 2009 and are now averaging 6.5% nationally.

All of these statistics bode well for further improvement in the retail sector.  Let's hope this trend continues and that other property types can follow in the footsteps of apartments and now retail.