The new U.S. Financial Data report out today from the St. Louis Fed shows that bank loans to business are still falling. This fits what we hear from entrepreneurs, that large banks have been systematically reducing availability of working capital loans for small companies—likely an unintended consequence of the Treasury bailout programs that make it bad business to make any loans that are not salable to the government.

The chart above shows that the lion’s share of the more than $100 billion (left scale) cut in total bank business loans since last fall is attributable to large banks (right scale). Small banks that do not have full access to the Treasury programs are still making loans.

Banks lend money to small companies, not big ones. Job gains (and losses) come from small companies, not big ones. That’s why this chart tells us we are going to see another lousy job report next week. I think we still have several months of job losses ahead of us before employment turns up again.

JR

As you know from my recent posts, I spend a lot more time thinking about balance sheets and a lot less thinking about GDP, than most economists. In this post I want to look at the balance sheet of the household sector. The most recent data from the Fed’s Flow of Funds report show that at the end of Q4/2008 (12/31/08) households (including nonprofit organizations) owned the following mix of assets.

Households hold 62% of their assets ($40.8 trillion) as financial assets like deposits, T-bills, bonds, stocks and mutual funds. They keep 31% ($20.5 trillion) in real estate assets, and they hold 7% ($4.4 trillion) in the form of consumer durable goods like used cars, old washing machines and computers (in all 38%, or $24.9 trillion in tangible assets). As I have written for years, these percentages represent portfolio choice decisions for people based on their perceptions of return and risk for each asset class. These portfolio decisions are exquisitely sensitive to changes in tax rates and monetary policy.

The table above shows the history of household balance sheet composition. The first thing to notice is the household balance sheet numbers are huge when compared with GDP (roughly $14 trillion per year) or its components like consumption, investment, net exports and government spending. At the end of 2008, people owned $65.7 trillion worth of total assets, made up of $24.9 trillion of tangible assets and $40.8 trillion in financial assets.

The tangible assets, in turn, can be divided into $20.5 trillion in real estate assets and $4.4 trillion in consumer durable goods. It makes sense that the assets on our balance sheet are so big. They represent all the economic activity that has ever happened–all the buildings we have built, all the cars and washing machines we have ever made–less the ones that are no longer in service. In the case of autos, for example, there are more than 15 used cars and trucks on the road and in the driveways for every one that will be produced (i.e., that will appear in the GDP accounts) in the U.S. this year.

In spite of what you read in the headlines, total household liabilities, including mortgages, installment credit and credit cards, add up to just $14.2 trillion. Net worth is a whopping $51.5 trillion–more than 3.6 times total debt and almost five times disposable personal income of $10.6 trillion.

So where is the financial crisis we read about? It is in the behavior of asset values over time. Our net worth of $51.5 trillion is $12.9 trillion (20%) lower than it was just 6 quarters earlier in Q2/2007. That puts our net worth roughly where it was at the end of 2004 ($51.9 trillion) but still much higher than it was a decade ago in 1997 when it was $33.3 trillion.

You can also see from the figures when the trouble started. Tangible asset values peaked in Q1/2007 at $28.4 trillion; since then they have declined by $3.5 trillion or 12.3%. Financial assets peaked 2 quarters later in Q3/2007 (when the leveraged loan and asset-backed securities markets froze up) at $50.5 trillion but have declined by $9.7 trillion or 19.2% since then. Essentially all the adjustment in both types of assets was due to price decline; the physical stocks of tangible and financial assets did not materially change during this period.

When asset values change abruptly, as they did over the past two years, it is always a demand story. That’s because over a short period asset supplies can’t change by much because new asset creation and retirement are small compared with the stock of outstanding assets. In this case it was the sudden drop in demand when investors pushed away from the asset-backed securities market a year and a half ago.

JR

California’s budget mess is front page news. Some are trying to figure out whether they can (or will) cut spending enough to live within their means. Others are looking for new revenue enhancers–we don’t call them taxes anymore or people will vote them down in elections. Both are missing the point. It’s not only the budget, but the balance sheet that needs attention.

California does not only have a tax and spend problem; it has a balance sheet problem. There are too many promises of future cash flow to pay for pensions and the like. California needs a balance sheet solution. Not the one that failed in last week’s election—borrowing more money and accounting with mirrors. California needs to sell assets and shrink liabilities in order to regain financial health. When a person or a company declares bankruptcy the judge takes your house, your car, your toys and your other ‘stuff.’ Although state governments cannot, formally, declare bankruptcy, the same medicine will work for them as well. Easier said than done.

Yesterday I wrote about the strange accounting practices for government entities used by the Federal Reserve Board in preparing their quarterly Z1: Flow of Funds of the United States reports. They provide detailed information about cash receipts and cash disbursements for federal, state and local governments, consolidated on p. 110 for all levels of government. They include the information on current receipts (tax collections) and current expenditures as well as information on government purchases and sales of all sorts of assets including spending to buy fixed assets (buildings etc., $513.1 billion annual rate in Q4/08). But in the consolidated balance sheet, which I have reproduced above, they conveniently forget to mention that governments own real assets.

According to the table, All levels of government owned $3280.4 billion in financial assets and had total liabilities of $10,171.3 billion on 12/31/08, which seems to imply that governments had a negative net worth position of nearly 7 trillion dollars (-$6,890.9 billion). But where are the $513.1 billion in fixed assets they reported governments buying in the flow of funds table? Indeed, where are all the other tangible assets–the land, the buildings, the machines, the trucks and buses) the governments purchased in all the previous periods? If they had included government holdings of tangible assets the statements would look much different. Indeed, they would reveal the immense stockpile of real assets on government balance sheets that are available for sale to meet the government obligations everyone is writing about. The federal government, for example, owns more than 700 million acres of land (not reported on their balance sheet either). These assets can be sold outright or they can be sold and leased-back. Either way the cash is available to pay obligations. Either way we would have more honest financial statements.

JR

I recently wrote about the fact that the forces impacting the U.S. economy’s balance sheet, at about $200 trillion, dominate those affecting GDP (just over $14 trillion) when thinking about interest rates and stock prices. A blog reader wrote to ask me where the $200 trillion figure comes from.

First, I want to point out that it is revealing that we have to ask the question. Why is it that people know so much about something so small (GDP) but so little about something so big (total assets)? I think it is because since the 1930′s macroeconomics has developed into a discipline concerned almost exclusively with who is spending how much money. Very little attention is paid to the capital base, or balance sheet, that makes it possible to produce the goods and services measured as GDP. A glance at a newspaper or any list of data produced by the government will convince you this is the case.

The best source of asset market, or balance sheet, information we have today is the document Z1: Flow of Funds of the United States produced after the end of each quarter by the army of economists working at the Federal Reserve Board.

The most recent (116 page!) flow of funds document, publish March 12, contains information about the balance sheet of the U.S. Economy on 12/31/08. I will warn you that you will have to dig for it–most of the 116 pages are devoted to measuring “flows of funds”, roughly the amount added and subtracted from balance sheets during the quarter. But you can find most of what you need if you hunt for it.

So what about the $200 trillion? I have constructed the table, above, by pulling figures from the report. The report reports balance sheets for some sectors of the economy but not others (which I find a little strange). They report balance sheets for 1) Households and Nonprofit Organizations, 2) Nonfarm Corporate Business (big companies), and 3) Nonfarm Noncorporate Business (small companies). These balance sheets show that at the end of 2008 housseholds and nonprofits owned $40,814 billion in financial assets like stocks and bonds and $24,905 billion in tangible assets like houses and cars, which adds up to $65,719 billion in total assets. Against that total, households and nonprofits owed debts, or liabilities, of $14,242 billion, which means they had net worth of $51,477. (These last numbers are in the document on p. 102 but not in the chart.)

Adding the three sectors together (Subtotal in row 4) produces a balance sheet with $104,049 in total assets divided between $58,639 in financial assets, and $46,301 in tangible assets.

Now it gets trickier. The Fed does not report complete balance sheets for the other sectors (farms, financial sectors, federal government, state & local governments, or rest of world (foreign owners). Instead, they report statements of financial assets, financial assets and financial liabilities. In other words, they leave out the fact that all these other sectors own tangible stuff like land, buildings, cars and computers, in addition to securities. I think that is a big mistake, reflecting the analytical bias in the macroeconomics community that somehow people consciously manage their portfolios of stocks and bonds but are passive owners of more than $46 trillion of real stuff.

We can use the Fed’s measures of financial assets held by all the sectors to get a pretty good figure for total financial assets in the balance sheet. Adding in farms, financials, governments and foreign owners brings the total financial asset figure up to $141,512 billion, which is reported on p. 115. (I say a pretty good figure because the document reports a $4,922 billion statistical discrepancy in getting to that figure themselves.) They do not report figures for tangible assets held by those “other” sectors, which is unfortunate because the “other” sectors are actually bigger than the ones they report.

That leaves us in an awkward position in trying to derive a total asset figure than makes sense for the overall U.S. economy’s balance sheet. One way to do it is to add up the numbers that we do know. I have done so in line 13. We know there are $141,512 billion in financial assets. We know that just three of those sectors own $46,301 billion in tangible assets. Adding those two numbers together produces a (reported) total asset number of $187,813 billion, pretty close to the $200 trillion number I wrote about at the top of the story. (The number would have been much closer 2 years ago before the recent drop in asset values.) Unfortunately, I have no idea what to call this number because it leaves out so many huge question marks.

If I weren’t so lazy I could dig up numbers to at least approximate the values of some of the question marks in the table. Farms own land and tractors, banks own buildings and ATM machines, governments own all sorts of crap including nearly a billion acres of land and all those cars you see on the highway that don’t have to buy license plates like you and me. And foreigners own a ton of stuff too. For today’s purposes all we have to know is that these things would add up to a very big number. And plugging these figures into the missing cells in the table would produce a total assets number far in excess of $200 trillion.

OK, that’s enough arithmetic. Why does this matter? It is to show you that the balance sheets are so big that almost any analysis of the economy that focuses on spending or saving or budget deficits alone, to the exclusion of the balance sheet, is almost certain to be wrong because balance sheet changes are so big. For example, household financial asset holdings fell from $50.5 trillion in Q3/07 to $40.8 trillion on 12/31/08 due to the collapse of stock and bond prices. And the value of their tangible assets fell by another $3.5 trillion due to falling home prices. Does anyone really think that the impact of this roughly $13 trillion drop in household net worth can be fixed by sending people checks for $700?

The most relevant application of this thinking today is how to understand the impact of the massive bailout programs on the economy and to say something meaningful about the impact of government borrowing on interest rates and stock prices. I will write more on these questions later.

You can read an analysis of budget deficits and interest rates using this approach in Chapter 4 of my new book, Lessons from a Road Warrior. You can get it from Amazon or get a signed copy directly from the John’s Book section of our website.

JR

About like it has been (4 week average is 628K, originally reported as 631K). Economy is starting to firm up a bit but the job numbers are being held down by the recent further tightening in bank credit lines for small businesses. Banks did this in order to focus bank resources on “things they can sell to the government in boatload quantities” that have a huge return for the bank. Banks have frozen working capital lines, home equity lines, personal lines and nonconforming mortgages (jumbos) for even top quality borrowers.  Jobs can’t pick up until small companies can borrow money again.

 

Yesterday I posted a piece about inflation and interest rates arguing that although recent inflation numbers have been very tame, the tsunami of bank reserves (=800%) released by the Fed is beginning to show up in inflation expectations, which is why long Treasury yields are rising. I ended with a warning that long-term bonds, not stocks, are the riskiest assets in our portfolios today.

A good friend asked me to review some of the logic in more detail. I will do so below:

1) The link between rising interest rates is not just a theory that might or might not be true. It is the definition of an interest rate, or yield. 

For example, In the chart below, if you pay pay $95.24 to buy a bond (really just an IOU) that promises to pay you $100 in one year then we would calculate its yield as r = ($100-$95.24)/$95.24 = $4.76/$95.24 = 5.0%.

If something changes in the marketplace and people lose interest in owning bonds so that their price falls to $90.91 then we would calculate their yield to be r = ($100-$90.91)/$90.91 = $9.09/$90.91 = 10.0%.

SO, SAYING THAT INTEREST RATES GO UP FROM 5% TO 10% IS THE SAME EXACT STATEMENT AS SAYING THAT BOND PRICES ARE FALLING.

2) the interest rate, or yield, (which is just a calculation we make by dividing a contractual interest payment by the price we pay for the security) on all sorts of securities rises and falls with inflation (actually expected inflation. Bet way to understand this is to think of the inflation rate as the “interest” you receive from owning a tangible asset like a house or a bar of gold. If you buy it for $100 this year and its prices goes up to $110 in one year (10% inflation) then the “yield” on the asset is $10/$100 = 10% (the increase in value divided by what you paid.) 

The logic is; inflation goes up => “yield” on real goods goes up => that makes the yield on real goods high compared with the yield on bonds and other securities => that makes people sell bonds to buy more houses and other hard assets => that pushes hard asset prices up and bond prices down => Falling bond prices increases the yield. => SO YOU DON’T WANT TO OWN BONDS WHEN THEIR PRICES ARE FALLING.

3) Over long periods the price level will be roughly proportional to the money supply. The money supply is roughly proportional to bank reserves. The Fed has increased bank reserves by +800% since last September. Together these mean that there is a big increase in the price level, hence inflation, baked into the recent Fed policy. When the economy starts to look a little more normal again (it is starting to do this already) people are going to worry about inflation unless the Fed does something to reverse their actions over the past 6 months.

Moral of the story–you don’t want to own bonds when people start worrying that inflation, hence interest rates, will go up.

JR

 

Last week we had reports on both producer prices (PPI) and consumer prices (CPI) for April. The headlines were about flat and falling prices. So why are interest rates going up?

April PPI showed finished goods up 0.3%, 0.1% ex food and energy and -3.7% from 12 months ago. Intermediate goods ex food and energy were -0.9% for the month of April and -10.5% over the last 12 months. Crude goods were -0.6% in April and a stunning -40% from a year earlier.

Consumer goods in April were flat (0.0%), and -0.7% from 12 months earlier. Energy costs were -8.5% over the past 3 months, and -25.2% from year earlier. 

So then why are interest rates going up? Not at the short end where the Fed is keeping fed funds and T-bill rates low, but at the long end as shown in the above chart of the 10 year Treasury yield. Rates have popped up by roughly one percentage point in recent weeks.

You can see the same bump in the 30 year Treasury yield above. Looking at the 30 year yield has fallen out of fashion due to the interruption in supply and thinness of the market compared with the ten year. But I think it is especially important because its duration is much closer to the duration of the stock market, roughly 25-30 years at today’s rate levels. In rough terms that means a one percentage point increase in the long Treasury yield (currently 3.17% for the 10 year and 4.18% for the 30 year) will reduce the intrinsic value (the expected value of free cash flow) of the S&P 500 by 25-30%.

So why are rates rising? Because bond market investors can see the end of the financial crisis that still dominates the headlines and the talk in Washington. They are looking beyond the credit crunch at the inflation implications of the Fed’s unprecedented tsunami increase in bank reserves (roughly +800%) since last September. They are right to do so.

I don’t think many economists would argue with the statement that an 800% increase in bank reserves, if allowed to remain in the market permanently, would increase the price level by about 800% over a few years. To clarify, that means the price of a quart of milk would go from $2 to $16! I don’t think that is going to happen because I believe the Fed and the political system would not allow it to happen. But it does mean that the Fed is going to have to start taking steps very soon to clean up their mess before it hits prices in a big way.

Here is the catch. The guys who are going to be in charge of cleaning up the mess by vacuuming up the 800% bank reserve increase (and an additional $90 billion that will come back onto reserves when consumers finally unclench their buttocks and re-deposit the $90 billion worth of $20 and $100 bills they have taken out of their bank accounts over the last year) are the same guys (the Federal Open Market Committee) that created the mess in the first place by first under-printing reserves in the year before last September, then over-printing reserves since then. The odds that they will handle this mopping up exercise with grace and agility are approximately equal to zero.

I’m not smart enough at this point to write the story of what happens when they try to do so. But I do believe we will see further increases in long rates as we approach the Fed hoover exercise, which could start to take place as early as the end of the year.

This has two implications to me: First, long-term bonds are the riskiest component of people’s portfolios in spite of what all the textbooks say. Second, the strong gains in the stock market caused by the Fed tsunami are real but temporary. There is no surer way to kill a long-term stock market that to increase bond yields.

JR

 

Currency held by the public is the single best measure of people’s level of fear about the stability of the financial system. When people worry their bank might fail they withdraw cash from their bank accounts and keep it at home in coffee cans or under the mattress. About one year ago people freaked out, as you can see in the chart below, which measures the increase in currency holdings over year earlier levels. The most recent figure shows that people have taken a massive $90 billion of currency out of the bank over the past year. To put that number in perspective, a year ago the entire US banking system held only $90 billion in total reserves. Since a dollar of currency withdrawn from the bank reduces bank reserves by exactly one dollar that means people have taken 100% of the country’s reserves out of the banking system over the past year.

A closer look, however, shows that the increase in currency holdings has run its course and that people are beginning to exhale. Withdrawals peaked a few months ago and have fallen sharply since then. The most recent figure actually fell a bit from $850.1 billion to $849.6 billion for the week ending April 27.  This shows an increase in confidence–or reduction in fear–that may be a factor in the recent stock price increase. At some point, when people return to normal levels of worry, they will likely re-deposit the entire $90 billion into their bank accounts. When that happens the economy will grow again and stocks will soar.

You can keep track of these numbers at the Federal Reserve Bank of St. Louis website where they are published every Thursday afternoon.

JR

I guess by now the secret is out that the U.S. housing market is a little soft. The February report isn’t going to change anybody’s mind. The median sales price fell another 2% (actually 1.9%, but who’s counting) to $195,900, 8.2% lower than a year ago. Prices fell in all 4 regions of the country. There were 2 positive signs; a slight increase in the number of transactions from 4.89 million to 5.03 million homes, and a reduction in the inventory of homes for sale from 4.16 million to 4.03 million homes. You can see the full report by clicking here, Existing Home Sales, February, 2008.

There are also signs that mortgage-backed securities are beginning to trade again. That’s what we need to fix the problem. Don’t hyperventilate yet but this report is OK, Dog.

JR